Big Tobacco Has Proven It Is No Longer a Soft Target

Big tobacco companies such as Philip Morris International (NYSE: PM  ) , British American Tobacco (NYSEMKT: BTI  ) , and Reynolds American (NYSE: RAI  ) are no strangers to litigation; they have spent most part of the past two decades fighting in the courts. However, it would now appear as if the risks of litigation against the industry have fallen significantly over the last five or so years.

According to data supplied by Reynolds American, the number of pending "smoking and health" cases against the company fell from 352 in 2001 to just 69 in the third quarter of last year. This evidence goes some way to suggest that after decades of being depressed by regulators, big tobacco is now starting to fight back .

Indeed, British American Tobacco, for example, has 450 people in its regulatory- affairs team and is no longer prepared to roll over without a fight. The aggressive lobbying to prevent plain-packaging regulations within the United Kingdom is a great example of this.

Moreover, it would appear that the regulations placed on big tobacco during the past decade or so have actually worked in favor of the industry. 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 entirely possible that the same could happen with electronic cigarettes, though that's a debate for another day.

A taxing problem
Aside from legal constraints, one of the biggest issues that has affected Philip Morris in recent years has been 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 Reynolds' 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, 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.

Time for change
With tobacco no longer presenting the soft target it once was, there are now some analysts who believe the sector is about to embark on a wave of acquisitions, reconsolidating the sector split apart due to the threat of litigation.

The two companies which are of particular interest are British American and Reynolds. You see, Reynolds American was created through the merger of British American's Brown & Williamson division with R. J. Reynolds. This combined entity left British American with a 42% stake in Reynolds. The two parties also signed a standstill agreement, preventing the Anglo-American company from increasing its share in Reynolds until July. A merger of this kind would be instantly earnings accretive for British American, and Reynolds' investors would likely receive a solid premium for their shares.

Foolish takeaway
Big tobacco has proven that it is no longer a soft target for regulators, and this is likely to lead to a wave of consolidation within the industry. Reynolds American would appear to be the best-looking target as British American looks to grab growth abroad. In addition, the industry continues to work with taxes, increasing margins and profit for investors. So all in all, it would appear that big tobacco is still far away from rolling over and accepting defeat.

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