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Looming Dangers Arise in Secret Underground Cigarette Trade

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Between 2006 and 2012, illegal smuggling of this product grew by more than 15%. The trade is largely run by organized crime. Government policy can be blamed for at least part of the problem.

Am I talking about cocaine? Marijuana? No, just the humble cigarette.

A recent report from research group KPMG, and commissioned by Philip Morris (NYSE: PM  ) , revealed that while total consumption of cigarettes in Europe has fallen in recent years, the illegal contraband and counterfeit trade has grown from 8.3% of total consumption to 11.1%. The report suggests that the high profitability and low risk of penalties attracts organized crime, which can use the trade as a cash cow to fund far more objectionable activities. An ad from British American Tobacco (NYSEMKT: BTI  ) goes as far as to suggest that the trade could even be indirectly funding terrorism.

There's a black market for everything
But why are people buying illegal cigarettes? Restrictions differ from country to country, but on the whole, cigarettes are legal and can easily be purchased. The trouble is that, because taxes and regulations vary so widely between countries, the price for consumers varies as well. A pack of Marlboros costs 6.69 euros in Sweden, and 13.18 euros in next-door Norway. In Ukraine, they sell for just 1.31 euros.

The differential makes it easy for smugglers to buy large quantities in cheap countries, bring them into more expensive countries, and sell them at some in-between price to profit. These large quantities are available in part because the large cigarette companies overproduce in cheaper countries. Ukrainian authorities estimate that the world's four leading tobacco companies -- Philip Morris, Japan Tobacco, Imperial Tobacco, and British American Tobacco -- produced about 130 billion cigarettes in the country in 2008, 30% more than the local market consumed or legally exported. The rest simply disappeared into the black market, making Ukraine one of the top sources of non-counterfeit black market cigarettes.

What's the impact?
Apart from the whole "funding organized crime" thing, the trade has a negative impact on both countries and cigarette manufacturers. It is estimated that governments around the world lost $40 billion to $50 billion in tax revenue in 2006, and that's just from lost cigarette taxes -- the losses are higher if you factor in things like unpaid income taxes from the money smugglers make.

As for manufacturers, there are two problems they face. The first should be obvious: If any of them are knowingly involved in undeclared overproduction, they may be criminally liable. Even if they aren't knowingly involved, government authorities are likely to decide that manufactures are at least partially responsible for cleaning up the mess. The report by KPMG, for example, was only commissioned by Philip Morris as part of a 2004 legal settlement with European regulators.

The other problem is that not all illegal cigarettes are legitimate ones being smuggled. Many are simply counterfeits, dressed up to look like a real pack of Marlboros or Superkings, and thus are not just a source of lost tax revenue but also lost sales for the companies. In 2012, 2.4% of all illicit cigarettes in Europe were counterfeit Philip Morris brands.

Not just Europe
While the KPMG report focused on Europe, this is not just a European problem. The United States is structurally very similar to the European Union, in that different states have different taxes and regulations and travel between states is relatively easy, far easier than travel between EU states, even. The Bureau of Alcohol, Tobacco, and Firearms estimates that the illegal cigarette trade costs local, state, and federal governments nearly $10 billion a year.

Because cigarette manufacturers in the U.S. are allowed to have more ornate packaging that is harder to duplicate, counterfeits are less of a problem here. However, Altria (NYSE: MO  ) has noted that counterfeits do account for part of the trade and are a problem for American manufacturers like itself, Lorillard (NYSE: LO.DL  ) , and Reynolds American (NYSE: RAI  ) .

A new law in Congress is intended to include certain United States territories in the definition of "state" to better enhance existing cigarette smuggling laws.

The Foolish bottom line
Research has shown that raising taxes on cigarettes reduces smoking, especially among kids, and that's a good thing. But the ATF has found that there is a direct relationship between taxes and illegal smuggling as well. Even if counterfeiting is a small part of the problem, the black market cigarette trade is bad for manufacturers, as it increases their liability and hurts their already embattled public image. Add these companies to My Watchlist to stay updated with any developments.

Tobacco companies have been under siege in the U.S. for decades, as waves of litigation, regulation, and anti-smoking campaigns have given the industry a black eye. Yet Philip Morris International focuses on overseas markets, where business prospects generally look brighter. Investors have been happy with its stock's performance, but is Philip Morris still a buy? Find out in The Motley Fool's premium research report on the company, which includes in-depth analysis of its opportunities and challenges ahead. To claim your report just click here now.

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