You may hear them lament the decline in volumes of cigarettes sold, but tobacco companies like Altria (NYSE: MO) and Lorillard (NYSE: LO) know they still have smokers over the barrel and can raise prices seemingly at will and not lose many customers because of it.
Now Reynolds American (NYSE: RAI) is following suit and increasing prices on its tobacco products, underscoring the cigarette companies' ability to make up in price whatever they're losing in volume.
Last week both Altria and Lorillard said they'd be increasing prices by Dec. 1, raising them as much as $0.06 to $0.07 per pack, while Altria's Philip Morris USA division was hiking prices on its snus by a like amount. Not to be left behind, Reynolds said it, too, would increase cigarette prices by $0.07 and Camel snus prices by $0.06 per tin.
The tobacco giants find themselves more profitable than ever despite the drop in number of cigarettes smoked because they have what economists would call an "inelastic market," meaning smokers just aren't all that price-sensitive.
Moreover, ever since the FDA got the power to regulate cigarettes back in 2009, it's received thousands upon thousands of applications for new tobacco products, presumably some that should stand a chance at challenging big tobacco's oligopoly, but none have come to market.
According to an article earlier this year in The Atlantic, despite receiving some 3,500 new tobacco product applications since 2009, the regulatory agency has effectively shut down their development by simply ignoring them or burying them in red tape. In what should be a competitive market where tobacco companies vie hard for a shrinking customer pool, the FDA is instead doing what the tobacco company themselves could not: providing an environment that allows the cigarette makers to raise prices virtually at will while padding their profits in the process.
With the Law of Unintended Consequences providing a tailwind, profits are growing by leaps and bounds, largely as a result of price hikes. Since 2009, Altria's gross margins have widened from 5.5% according to Standard & Poor's CapitalIQ, to 55.1% this past September, while net margins went from 19.1% to 29.1% over the same time frame. Reynolds American went from gross margins of 46.7% to 53.7% and net margins of 11.3% to 18.9%.
Lorillard's gross margins similarly widened, but it net margins dipped in 2012 as a result of a lawsuit settlement and the acquisition of blu eCigs, its industry-leading electronic cigarette business that it also expects to be a big profit center in the future -- if regulators don't kill it off.
Analysts are bullish about the tobacco companies because they've been able to institute regular price increases on their products while also cutting off-invoice promotional allowances. With customers expecting to pay exorbitant prices for their vice of choice, and the aid they're seemingly receiving from the FDA, there doesn't appear to be anyone willing or able to say no.
Since big tobacco also sports lush dividends yielding 4% to 5%, investors should be hard-pressed to find a better investment opportunity that isn't obfuscated by smoke and mirrors.
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