So This Is How Big Tobacco Dies ...

It's been a little more than 50 years and three weeks since the U.S. Surgeon General at the time, Luther Terry, issued a smoking and health report linking the harmful effects of smoking to dangerous diseases such as lung cancer and heart disease. At the time it was a landmark report, because it set in motion a series of laws designed to regulate how the tobacco industry advertised to consumers, and mandated health warning labels be placed on cigarette packs just one year later.

Fast-forward 50 years, and the landscape for Big Tobacco has changed dramatically. A number of states have indoor smoking bans, including heavily populated California, which in 1995 was a pioneer in introducing the first indoor smoking ban for restaurants and bars. Since then, a number of states have joined the list, with New York City taking it a step further and banning smokers from lighting up at beaches, in public plazas, and from even using e-cigarettes in these public settings. 

More than anything, public awareness and anti-smoking campaigns have really been stepped up over the past five decades. Since 1965, the percentage of adult smokers has dropped precipitously from greater than 40% to less than 20% as of 2011.


Source: Centers for Disease Control and Prevention.

Similarly, after a brief rise in 1990s, the percentage of student smokers has dropped from a peak of nearly 40% to less than 20% as well.

Helping deliver these encouraging results has been a number of aggressive and graphic awareness campaigns from the Centers for Disease Control and Prevention that have opened the eyes of a nation as to the negative health effects of smoking. Also, a number of states and the federal government have made it quite apparent that if you're going to smoke, it's going to hurt you in your pocketbook, with taxes on tobacco products soaring in just a few decades.

Source: CVS Caremark.

So this is how Big Tobacco dies ...
Last week, the war against tobacco took another interesting turn, with the nation's largest drugstore, CVS Caremark (NYSE: CVS  ) , announcing that it will stop selling tobacco products by Oct. 1. The move is being undertaken because it doesn't fit with CVS's theme of helping improve its customers' health, and could be the impetus that sets off a wave of chance throughout the entire retail sector.

The move isn't going to come without consequences for CVS, which derived about $1.5 billion in annual sales from tobacco product sales as well as an additional $500 million in add-on sales to tobacco consumers. In total, that's a potential $2 billion dollar hit for a company that brought in $123.1 billion in revenue in 2012, and a negative impact of $0.06-$0.09 on its EPS.

Early indications are that fellow drugstores are considering the idea, but no decision has been made as of yet. According to CNN, Walgreen (NYSE: WAG  ) spokesman Jim Graham had this to say:

We have been evaluating this product category for some time to balance the choices our customers expect from us with their ongoing health needs. We will continue to evaluate the choice of products our customers want, while also helping to educate them and providing smoking-cessation products and alternatives that help to reduce the demand for tobacco products. 

What does this mean for domestic tobacco producers such as Altria (NYSE: MO  ) , Reynolds American (NYSE: RAI  ) , and Lorillard? Not to sound overly dramatic, but it could mark the beginning of a slippery decline for Big Tobacco.

The noose tightens
Big Tobacco has felt tighter regulations coming on for quite some time in the U.S., with both Altria and Reynolds American proactively cutting back their workforce in 2011 and 2012 by 15% and 10%, respectively. The truth of the matter is that cigarette volumes are declining for many of the major domestic producers, and only price increases, cost-cuts, and the addictive qualities of the product have kept their profits high enough to satisfy investors.

Source: James Stenberg, Wikimedia Commons.

Altria, which is known best for its Marlboro brand, reported a 2.6% decline in net revenues for the fourth quarter as total domestic cigarette shipments tumbled 5.8%. The scary thing is that it's not just premium brands anymore that are feeling the pain. Marlboro's discount brands also saw shipment volume decline by 54 million to 2.52 billion cigarettes, a drop of 2.1%.  

It's much the same story for Camel brand retailer Reynolds American, which has delivered a 0.5% revenue decline through the first three-quarters of fiscal 2013 while cigarette volume dipped 4.3% in the third quarter.

This new complication from CVS could cause public sentiment to persuade Walgreen and Rite-Aid, as well as other retailers of health products, such as larger chain grocery stores, to make the same move.

Turning over a new leaf
The tobacco industry is one that is inherently governed by copious amounts of laws and the ongoing threat of lawsuits. The easiest way to avoid these threats is by simply not investing in tobacco producers. Period!

However, if the allure of the pricing power and cash flow proves to be too great, then investors really should consider ignoring the majority of domestic producers that are inherently tied to increasingly strict U.S. regulations and instead look overseas to a company like Philip Morris International (NYSE: PM  ) .

Philip Morris features the Marlboro brand outside the United States and currently sells seven of the top 15 international brand cigarettes. Although it does face stiff regulatory smoking laws in some of the foreign nations it operates in, such as Australia, it can easily maneuver around these more difficult growth opportunities by focusing on burgeoning emerging markets such as China and India, where smoking laws are very relaxed and a considerable number of a growing middle-class population smokes.

It remains to be seen whether domestic producers can reverse their shipment declines, but if public sentiment grows too strong based on CVS's move, expect other retailers to follow. Some had predicted tougher regulations or lawsuits would be the eventual demise of Big Tobacco. Instead, it could be something as simple as retailers refusing to sell the product in their stores that cripples this dominant industry.

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