Why the Growing Illicit Cigarette Trade May Benefit Philip Morris International and Altria Group

The black market is siphoning off revenue from tobacco companies and governments alike, but it may end up benefiting Philip Morris and Altria.

Feb 2, 2014 at 11:00AM

It is no secret that many developed nations would like to eliminate cigarette smoking altogether and as quickly as possible. One of the most effective ways of curbing consumption has been to raise excise taxes on cigarettes. Higher taxes lead to higher cigarette prices, which encourages consumers to buy fewer of Philip Morris International (NYSE:PM) and Altria Group's (NYSE:MO) products.

However, there is a limit to the effectiveness of taxation in discouraging consumption. Once taxes push prices up enough, evidence suggests that consumers turn to the untaxed and unregulated black market to buy cigarettes -- a behavior that is not good for tobacco companies, governments, or consumers. As the black market grows, Philip Morris finds itself in an unlikely alliance with governments to keep demand in the legal channels.

Illicit trade directly linked to taxation
Illicit cigarettes usually take the form of either counterfeit products that look like real brands (e.g., counterfeit Marlboro) or legitimate products that are sold tax-free. Some 525 billion cigarettes -- or 8.4% of worldwide consumption -- escaped taxation in 2012, including 30 billion cigarettes in the United States and 315 billion cigarettes internationally. Illicit trade in the European Union, or EU, increased 43% from 2000 to 2010 and represents about 8.2% of the EU cigarette market.

The profit on illicit sales can be enormous. Without excise taxes, Philip Morris would generate an 87% gross margin and Altria would earn a 68% margin. Including the tax, however, Philip Morris' margin drops below 30% and Altria's below 40%. Illicit sales can undercut the retail price and still earn a huge margin.

There is a direct link between illicit cigarette share of the total market and excise taxes on cigarettes. For instance, Bulgaria experienced a 647% increase in illicit trade between 2000 and 2010. Although illicit sales increased from 2000 to 2008, the biggest jump came right after a large excise tax increase in 2008.

Ultimately, countries that already have high cigarette taxes cannot raise the tax faster than the purchasing power of the smoking population. Smokers tend to be poor, so they cannot afford to pay more for cigarettes nor can they easily give up the addiction. When cigarette prices exceed poor consumers' budgets, consumers turn to the black market in droves.

Illicit trade hurts all stakeholders
The unregulated black market is bad for tobacco companies, governments, and consumers alike. The effect on tobacco companies is obvious: the 8.4% of the market that consists of illicit sales is lost revenue for tobacco companies. Counterfeit cigarettes bearing Philip Morris' brands represented 28% of the illicit EU market in 2010, suggesting Philip Morris is losing substantial business to the black market.

Governments also lose revenue to the black market; EU member nations lose up to 10 billion euros per year in taxes, and the United States loses an estimated $5 billion per year in tax revenue avoided by illicit sales.

Tobacco companies and governments clearly have much to gain from eliminating black-market goods, but so do consumers. If a government's intention is to ween its citizenry off of harmful products (and there is reason to believe this isn't every government's full intention), then discouraging the illicit cigarette trade should be its top priority. Counterfeit products may not contain adequate warning labels and may be sold indiscriminately to underage smokers.

What it means for Philip Morris and Altria
Between regulated Marlboro and illicit cigarettes, governments should encourage the consumption of Marlboro. The numerous government-funded studies and press stories that have appeared within the last few years suggests that developed countries are ready to fight back against the black market. But this may require some tough choices.

For instance, high taxes are the key driver of black-market sales. Honest governments will recognize the limits to taxation -- excise taxes should not outgrow the poorest consumers' purchasing power. In addition, forcing packages to be dull and undifferentiated makes it easier for counterfeiters to copy popular brands; allowing for more intricate designs would cut down on counterfeiting.

Developed countries are unlikely to roll back excise taxes, but the illicit cigarette trade may discourage them from raising taxes much higher than current levels. This would be welcome news for Philip Morris and Altria investors -- and, ultimately, more tax revenue for government coffers.

Three dividend stocks you need to own in 2014
If you're looking for some long-term investing ideas, you're invited to check out The Motley Fool's brand-new special report, "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so simply click here now and get your copy today.

Ted Cooper 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

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information