Big Tobacco Is Not Worried about Quitters

Aside from the ethical argument, one of the things that concerns investors most about investing in tobacco is the declining number of smokers within the United States. In particular, investors are concerned that as a rising number of smokers are kicking the habit, profits of domestic tobacco companies such as Reynolds American (RAI), Altria (MO 0.86%), and Lorillard (LO.DL) are going to evaporate.

Indeed, according to data supplied by the Wall Street Journal, 289.5 billion cigarettes were sold within the US during 2012. In comparison, back during 2003 around 400 billion cigarettes were sold annually. Clearly the decline in the volume of cigarettes sold within the country has been quite significant.

All in all, this implies that the profits of the domestic tobacco companies should be falling. However, that is not the case. Actually, during the period of 2008 to 2012, the revenues and profits of Reynolds, Altria, and Lorillard have only pushed higher.

As we can see from the table, the number of cigarettes sold within the US has declined 17.3% during the past five years. However, none of the three domestic tobacco companies have seen their revenues decline to the same degree.

Still, investors are right to express concern about the sliding volume of cigarettes sold within the United States. However, as of yet it does not seem that big tobacco is worried.

Why aren't these companies worried?
You see, big tobacco continues to increase prices to offset declining volumes. For example, Altria's most recent price hike came into effect on Dec. 1 as the company added $0.07 per pack to the price of Marlboro cigarettes. This follows a similar $0.06 increase in June.

According to data supplied by the Tobacco Atlas, the average price of a pack of Marlboro cigarettes within the United States is $6.36, which implies that the total price increase of $0.13 per pack for this year would be a 2% rise all-in-all. Note that this calculation includes taxes.

Now, we can factor this into Altria's results to see how it helps keep the company's profits rising.

Specifically, for the first nine months of this year, the volume of Marlboro cigarettes sold by Altria declined by 3.8%. However, with the company instigating price increases of 2%, this effectively means that the revenue received from the volume of cigarettes sold declined by only 1.8%. These numbers, along with price increases across the rest of the company's tobacco portfolio and an increase in the volume of discount cigarettes sold, meant that Altria's revenue from cigarettes fell only 1% during the first nine months of 2013.

What's more, lower costs and lower excise taxes helped Altria's adjusted operating income from smokeable products rise 16% year-over-year for the nine months ending in September. 

Not yet following the market leader
However, as of yet, neither Reynolds nor Lorillard have followed Altria's most recent price hike, although both companies have already increased prices earlier this year.

Nevertheless, it remains to be seen if Lorillard actually needs to push up prices as the company continues to steal market share from its peers. Specifically, at the end of the fiscal third quarter Lorillard's market share of the United States domestic retail tobacco market was 14.9%, up 0.5% year-over-year. This extra market share helped Lorillard offset falling volumes of cigarettes sold. All in all, Lorillard's volume of cigarettes sold for the nine months ending Sept. 30 only declined a minuscule 0.1%. 

Unfortunately, Reynolds' sales have not held up as well as those of Lorillard and Altria. Despite a good third quarter, the company's volume of cigarettes sold declined 6.3% during the last nine months. Still, cost cutting helped boost the company's bottom line, and operating margin expanded from 31% to 40%. 

Foolish summary
So all in all, while the volume of cigarettes sold within the US continues to decline, domestic tobacco companies are not worried. A combination of price hikes, cost cutting, and lower excise taxes are all helping to widen these companies' profit margins and push sales as well as income higher. It would appear that big tobacco is able to withstand lower volumes for now.