Big Tobacco Is Working Around Regulation and Taxes

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.

Other income investment opportunities
One of the dirty secrets that few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend paying brethren. The reasons for this are too numerous to list here, but you can rest assured that it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2785402, ~/Articles/ArticleHandler.aspx, 8/30/2014 10:36:44 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement