The Growth of the Illegal Cigarette Trade Poses a Huge Risk to Big Tobacco

Big international tobacco players Philip Morris, British American, and Altria are now more at risk of being impacted by the illegal tobacco trade than ever before.

Feb 9, 2014 at 12:33PM

Big international tobacco players Philip Morris (NYSE:PM), British American (NYSEMKT:BTI) and Imperial Tobacco are now more at risk of being affected by the illegal tobacco trade than ever before as governments continue to become more aggressive in their war against big tobacco. What's more, this worrying trend is not just limited to international tobacco. Domestic US tobacco companies are suffering from the illegal trade, and with a 50% market share, Altria (NYSE:MO) is likely to be most affected by this.

Recent catalyst
The illegal cigarette trade has been an issue for some time. However, the recent drive by developed nations to introduce laws that prohibit the sale of cigarettes in branded packaging has made it much easier for the illegal market to operate. The full extent of this has recently been revealed within Australia, the first country to introduce these laws. A study by accounting firm KPMG LLP found that in the one year that these regulations have been in place, illicit tobacco sales have increased by 1.5% to 13.3% of total shipments, while consumption of tobacco has not changed.

Along with plain packaging, the Australian government hiked excise taxes on cigarettes to the point that taxes now make up around 63% of the price of a pack of cigarettes within the country. In Australia, a packet of 20 of Philip Morris' Marlboros sells for around US $14, versus $1 in Vietnam and $2.30 in China -- as you can imagine, this is not helping the battle against the illicit tobacco trade.

Working in tobacco's interest
That being said, these rising taxes are actually working in favor of big tobacco. Indeed, according to Alison Cooper, chief executive of the world's fourth-largest tobacco company Imperial Tobacco, excise taxes give tobacco companies more price leverage. In other words, tobacco companies can sneakily raise prices when excise taxes increase, as consumers are less likely to notice.

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 by 0.5% to 1% every year. Altria reported a 1% increase in operating margin for the full year of 2013, from 41.2% for 2012 to 42.2% for 2013.  While margins are expanding, sales continue to decline, so it's not all good news. 

Not all good news at all
Still, the increasing volume of illicit tobacco sales is of serious concern to big tobacco. I've already covered how Marlboro cigarettes are priced differently within Asia above, and the region is a key growth market for Philip Morris and British American. With prices so low, at present there is plenty of room for companies to increase and improve profits.

However, according to a recent report entitled "Asia-11: Illicit Tobacco Indicator 2012," an international study compiled by the International Tax and Investment Centre and Oxford Economics, the volume of illicit cigarettes being smoked within developing countries is on the rise and this is likely to mitigate any effects of price increases. For example, it is estimated that illicit cigarettes include 26% of the cigarettes consumed within Pakistan and more than 30% of the cigarettes consumed within Hong Kong. Further, estimates put the number of illicit cigarettes consumed within Vietnam at 20% of the market and 10% of the Australian market. 

It's not just the developing world where tobacco smuggling is prevalent. It is estimated that due to the high rate of tax on cigarettes within New York, around 60% of the state's cigarette market is illegal. It's estimated that this illegal market results in costs of at least $1.7 billion in tax revenue and 6,700 jobs. Meanwhile, Chicago is vying to raise its cigarette taxes by $0.75 per pack, making its cigarette taxes the highest in the country. This will only serve to fuel the illegal tobacco trade.

Indeed, at present the states' cigarette taxes are the second highest in the country and tax revenue has plummeted from a high of $33 million in 2006 to $17 million as of 2013. For the most part, this drop is due to smokers crossing state lines to get their fixes in Wisconsin and Indiana where taxes are less oppressive. Nevertheless, there is also scope here for these illegal cigarettes to be manufactured by smugglers themselves, which is of concern for big tobacco and health care agencies.

Foolish takeaway
The take away here is the fact that the global illegal cigarette trade is growing and this will to some extent impact big tobacco. Investors need to be particularly aware of plain cigarette packing laws, which are not denting consumption but are leading to higher levels of illicit cigarettes entering the market.

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Rupert Hargreaves owns shares of Altria Group. 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.

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