Big Tobacco Is Working Around Regulation and Taxes

Big tobacco is no stranger to regulation and taxes, but British American Tobacco and Philip Morris are getting these restrictions to work in their favor.

Jan 7, 2014 at 7:00AM

Many investors are concerned, and rightly so, that the tobacco industry is in terminal decline. Regulation, taxes, and health issues are three of the main factors buffeting the industry, pushing investors away. What's more, these factors are also pushing customers away and investors are concerned that one day cigarette sales will all but evaporate, leaving companies such as Philip Morris International (NYSE:PM), British American Tobacco (NYSEMKT:BTI), and Lorillard (NYSE:LO) with no revenue, or profits to distribute to shareholders.

However, far from being squashed by strict regulation and excise taxes, big tobacco is rejoicing as regulation is actually working in its favor. A great and famous example of this was the advertising ban levied on tobacco companies by regulators back in the early 70's.

Originally, this ban on advertising was thought to be a great idea, removing the allure of tobacco products and helping to slow the growth of tobacco consumption. But as it turned out, this only served to benefit tobacco companies as they saved billions on marketing spend every year, and profits rose for a number of large cigarette brands. It is enitrely possible that the same could happen with electronic cigarettes.

A taxing problem
Aside from legal constraints, one of the biggest issues that has affected Philip Morris in recent years is the rising amount of excise taxes the company must pay on its cigarettes. These high taxes have been placed on tobacco as a 'sin tax,' aimed at trying to recoup some cash from the consumption of products that are generally considered to have a negative effect on economic output due to detrimental health effects. Of course, this tax is in its entirety passed onto customers, but high taxes are still, to some extent, impacting Philip Morris, British American, and Altria's bottom line.

We can quite clearly see the effect of these taxes on Philip Morris' profit and shareholder returns. For example, during the quarter ended Sept. 30, 2013, Philip Morris had revenue of $20.6 billion with a production cost of only $2.6 billion, which resulted in a gross margin of 87%. However, excise taxes for the period amounted to $12.7 billion. After including both excise taxes and the cost of goods sold, Philip Morris' gross margin was compressed to only 26%. If we include selling and administrative costs, the company's operating margin drops further to 18%. Furthermore, after including income taxes, the company's net profit margin declines to slightly less than 12%.

This is a good thing?
However, although these taxes take a huge chunk out of tobacco-company profits, they are also working in favor of big tobacco.

Indeed, according to Alison Cooper, chief executive of Imperial Tobacco, the world's fourth-largest tobacco company, excise taxes give more price leverage. In other words, tobacco companies can sneakily raise prices along with excise tax increases, and consumers are less likely to realize.

To prove this point, just look at the operating margins of Philip Morris and British American. Philip Morris' operating margin has expanded from 42% during 2006 to 47% as of 2013. Meanwhile, British American expects that its operating margin will expand 0.5% to 1% every year. Still, while margins are expanding, sales continue to decline, so it's not all good news.

Not such a good thing
Closer to home, Lorillard is facing impending regulation on its most profitable product, menthol cigarettes.

Around 90% of Lorillard's sales are menthols, and this means that if the U.S. Food and Drug Administration moves against the product, and there is plenty of speculation that it will, the company will take a significant hit (more on this here). However, Lorillard has another string to its bow, electronic cigarettes, or e-cigs, and this is where the company might be able to benefit from regulation.

You see, there is plenty of speculation that regulators will move against the way e-cigs are marketed, and proposals could come as soon as this month. Rather than retreat from the marketing space though, e-cig producers are ramping up marketing spend, unleashing what has been described as a 'flurry' of new TV ads, to reach consumers and cement their brands.

This is where Lorillard will benefit, as its Blu eCig brand has already established itself as the e-cig category leader with approximately a 49% share of the market. If an advertising ban were brought in, then Lorillard would be in prime position to benefit, as the company would no longer need to spend on marketing; but with a dominant position in the industry, the company would likely see its market share continue to grow as word spread.

Foolish summary
Investors should not be overly concerned about regulation and taxation within the tobacco industry. It would appear that for the most part, tobacco companies are getting regulatory hurdles to work in their favor, and rising taxes are only improving profits. What's more, an advertising ban on e-cigs within the United States could work in in Lorillard's favor as the company is already dominant in the market.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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