Despite efforts to convince the ethical investment industry that they conduct their businesses “responsibly,” tobacco companies are universally excluded from ethical funds. Not that this has any effect on their financial performance. Bolstered by volume growth in emerging markets and pricing power in developed economies, the industry is thriving.
The public smoking bans, curbs on advertising, massive lawsuits and heavy taxes imposed on the much-maligned industry led many to believe that cigarette makers are “going down the drain,” says Hermann Waldemer, CFO of Philip Morris International (PMI). But with healthy profit growth and cash flow, the shares of Altria, PMI’s parent company, and its peers have comfortably outperformed the benchmark stockmarket indices in recent years. (See “Up in Smoke” at the end of this article.)
Lausanne-based PMI runs all of Altria’s tobacco businesses outside of the US. After spinning off its Kraft food unit earlier this year, Altria is now expected to do the same with its international tobacco arm, possibly this month, distancing PMI from the hundreds of lawsuits faced by its American colleagues.
PMI sold more than 831 billion cigarettes last year, achieving 25% of world market share (excluding the US and China) and accounting for about two-thirds of Altria’s tobacco-related revenue and profit. Billing itself as “the most profitable international tobacco company,” it is a bellwether for the industry. Waldemer, a 20-year PMI veteran and former chairman of the German tobacco manufacturers association, is well placed to put the industry — past, present and future — into context.
Home and Away
More than 80% of the world’s 1.3 billion smokers live in developing countries, according to the World Health Organisation (WHO). Sales in many of these markets are expected to grow modestly in the coming years, in sharp contrast to the developed world, where increasing health awareness and stricter regulation is driving down volumes across Europe, the US and Japan.
Generating around two-thirds of its sales in emerging markets, PMI spent more than $1 billion earlier this year buying out minority partners in Pakistan and Mexico. Profits, however, are another story. Around 60% of PMI’s profits come from mature markets, where margins are 2.5 times higher than in emerging economies. Defending market share in these profitable markets kicked off a recent wave of consolidation in the industry, with Japan Tobacco buying UK-based Gallaher while Imperial Tobacco, also based in the UK, looks set to capture Franco-Spanish Altadis. Around 90% of the European market is now in the hands of the industry’s four largest companies.
A WHO study found that every 10% increase in tobacco prices results in a 4% reduction in demand from high-income countries, half of the 8% reduction observed in low-income countries. This explains the durability of profits in mature markets, despite higher taxes and shrinking volumes. “In this context, ‘mature’ markets shouldn’t have a negative connotation,” insists Waldemer.
“The broad misperception of tobacco is that it’s a dying industry, while the more sophisticated misperception is that there is no further growth in mature markets,” notes Erik Bloomquist, an analyst at JPMorgan in London. With tax accounting for 60% to 80% of a packet’s retail price, passing tax rises to sales prices generates disproportionately beneficial growth in manufacturers’ revenue that “drops straight through to Ebit,” he notes.