Keeping those factors in mind, how does the road ahead look for the three largest tobacco companies in America – Altria Group Inc (NYSE:MO), Reynolds American, Inc. (NYSE:RAI) and Lorillard Inc. (NYSE:LO), and should investors still have faith in this oft-vilified industry?
First quarter breakdown
All three companies recently reported their first quarter earnings. Their results were similar, featuring rising profit, flat revenue growth, and declining cigarette shipment volumes. Let’s take a look and how these three companies fared during the first quarter.
1Q Year-on-Year Profit Growth | 1Q Year-on-Year Revenue Growth | Cigarette Sales Volume | Total U.S. Market Share | Biggest Brand(s) | |
Altria | +16% | -2.1% | -5.2% | 50.5% | Marlboro |
Reynolds American | +88% | -2.6% | -5.6% | 26.1% | Camel, Pall Mall |
Lorillard | +47% | +6.0% | -2.0% | 14.9% | Newport |
Source: 1Q Earnings Reports
Although Altria Group Inc (NYSE:MO) grew the least out of the three companies, its market share continues to rise, up from 50% in the prior year’s quarter. Altria Group Inc (NYSE:MO)’s Marlboro brand controls a whopping 42.6% of the U.S. cigarette market by itself. Meanwhile, Reynolds American, Inc. (NYSE:RAI) reported rising profits but lost market share, while Lorillard Inc. (NYSE:LO)’s market share rose slightly, boosted by strong sales of its menthol brands.
Some investors believe that investing in the U.S. tobacco industry – which is shrinking due to increasing regulation, higher excise taxes, and more health conscious consumers – is a foolish strategy. Yet I believe that these three leading tobacco companies are tightly run ships which have used strong dividend payouts, aggressive share buybacks, strategic acquisitions and tactical cost-cutting strategies to continue growing.
Alternative tobacco
Investors shouldn’t fret about declining cigarette sales volume in the United States. To offset these expected losses, Altria Group Inc (NYSE:MO) and Reynolds American, Inc. (NYSE:RAI) own steadily growing brands of snuff, cigars and smokeless alternatives.
Through its acquisition of UST, Altria Group Inc (NYSE:MO) controls over half of the domestic snuff market with its Copenhagen and Skoal brands. Reynolds American controls 33% of the snuff market with its Grizzly and Kodiak brands.
Altria Group Inc (NYSE:MO) also entered the niche cigar business through its purchase of John Middleton Cigars, which controls 30% of the domestic market for machine-made cigars with its Black & Mild brand. It also owns stakes in brewer SABMiller and winemaker Ste. Michelle Wine Estates. Reynolds American, Inc. (NYSE:RAI) also invested in nicotine gum Zonnic to diversify away from cigarettes.
Although these non-cigarette brands comprise a much smaller slice of the top line than traditional cigarettes, they are steadily rising in significance. Lorillard Inc. (NYSE:LO), which has traditionally been the market leader in menthol cigarettes, notably offers fewer non-cigarette products.
However, Lorillard has a major ace up its sleeve – electronic cigarettes.
Electronic cigarettes
Many analysts believe that electronic cigarettes will be the next hot product for the tobacco industry worldwide. E-cigarettes use an electric charge to convert nicotine cartridges into vapor, which is inhaled to deliver nicotine directly into the lungs without cancer-causing smoke and tar. They even have electric lights on the tips that help smokers replicate the feeling of smoking.
Lorillard Inc. (NYSE:LO) owns blu eCigs, which controls 40% of the U.S. electronic cigarettes market. Lorillard estimates that e-cigarettes replaced the consumption of approximately 600 million cigarettes during the first quarter. This translates to a possible 2.4 billion e-cigarettes sold annually – or 1% of the total domestic cigarette market. That sliver has been steadily growing since 2006. Bullish analysts forecast that total industry-wide e-cigarette sales this year could double year-on-year to $1 billion.
Lorillard Inc. (NYSE:LO) announced that it was launching a new rechargeable e-cigarette kit that will sell for half the price of its current product. Stronger marketing initiatives and wider distribution channels helped blu eCigs contribute $57 million to Lorillard Inc. (NYSE:LO)’s top line in the first quarter, up from $39 million in the fourth quarter. Retailers have also noticed the rising popularity of blu eCigs – distribution points rose to 80,000 in the first quarter, up from 50,000 in the previous quarter.
Meanwhile, Reynolds American, Inc. (NYSE:RAI) has launched its Vuse brand of e-cigarettes, which it plans to expand further this year. Reynolds has not disclosed how much sales Vuse generated during the prior quarter, but the contribution is likely to be small.
Altria is notably lacking an e-cigarette product to rival blu eCigs and Vuse, but the company has announced that it plans to release an e-cigarette later this year. Altria Group Inc (NYSE:MO)’s cash position notably rose to $3.78 billion, up from $2.90 billion a year ago, which means that it could easily acquire some smaller e-cigarette brands to unify under its banner.
Sidestepping regulations
Electronic cigarettes could help tobacco companies sidestep health and advertising regulations, since they aren’t really tobacco products. The Food and Drug Administration is currently evaluating how to properly regulate e-cigarette sales, since health tests of nicotine vapor have been inconclusive.
Since FDA tests are likely to show that e-cigarettes are healthier than traditional cigarettes, tobacco companies could sidestep marketing regulations, which currently require large, graphic health warnings on cigarette packages. Tobacco companies could also be allowed to advertise e-cigarettes through various media outlets, since they would be categorized closer to nicotine gum and patches than traditional cigarettes.
E-cigarettes could also help big tobacco companies escape tobacco-focused excise taxes, that are constant weighing on their top line growth. They could even help circumvent some indoor smoking bans.
The Foolish Bottom Line
Although the industry-wide decline of cigarette sales looks bad for the domestic tobacco industry, I believe that these three companies will continue to grow over the next decade. Rising sales of smokeless products, more diverse products such as cigars and nicotine gum, and the exciting new growth industry of e-cigarettes are all reasons to stick with these slow and steady stocks, which have all handily outperformed the S&P 500 by the wide margin over the past three years.
All three companies also pay some hefty dividends that complement their stable growth. Altria Group Inc (NYSE:MO) pays a 4.9% yield, Reynolds American, Inc. (NYSE:RAI) offers 5.0%, and Lorillard Inc. (NYSE:LO) pays 5.10%. Therefore, I believe that these tobacco stocks, as well as their international counterparts Philip Morris International Inc. (NYSE:PM) and British American Tobacco, belong in any long-term investor’s portfolio.
The article The Road Ahead for Domestic Big Tobacco originally appeared on Fool.com and is written by Leo Sun.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
