How Big Tobacco Could Affect the Legal Marijuana Business

Marijuana legalization is a contentious issue that seems to have a clear end: Legalization and taxation may soon spread across the U.S. With the legalization already under way in Colorado and Washington state, it is easy to imagine similar relaxing of marijuana laws in other states in an attempt to replenish cash-strapped state budgets. Federal legalization could follow, allowing for the development of interstate marijuana-selling corporations.

Altria Group (NYSE: MO  ) , Reynolds American (NYSE: RAI  ) , and Lorillard (NYSE: LO  ) are obvious candidates to become the biggest nationwide marijuana-cigarette distributors. Parody magazine Abril Uno ("April One") ran a story announcing that Philip Morris will introduce Marlboro M's in Colorado and Washington to take advantage of marijuana legalization in those states. Of course, the story was false, but not implausible. In fact, there are only two major hurdles keeping Altria and friends from dominating the nascent market.

First hurdle: federal regulation
Federal regulation is the first major hurdle that must be cleared before big tobacco enters the marijuana business. Although Gallup finds that a clear majority of Americans -- 58% -- favor legalizing marijuana, it could be much longer before federal legalization takes hold, if ever. President Obama, a nominal supporter of marijuana prohibition, seems content to allow legalization to play out on a state-by-state basis.

In an interview with Fast Company, an Altria representative said that because of federal prohibition, Altria has no plans to sell marijuana cigarettes. As long as the threat of federal prosecution remains, banks will be unwilling to provide services to marijuana-related businesses, and interstate distribution will be virtually impossible. As a result, small businesses stand the best chance of succeeding in the marijuana market.

However, with growing public support for marijuana decriminalization and economic incentives for Congress to act, the door may soon be open for legal interstate marijuana distribution. Harvard economist Jeffery Miron published a paper that pinpoints $13.7 billion in potential government savings from legalization -- $6 billion in additional tax revenue and $7.7 billion in enforcement costs. More strikingly, the Federal Bureau of Prisons reports that half of all inmates in federal prisons are there for drug-related offenses. According to the U.S. sentencing commission, a little more than one quarter of imprisoned drug offenders between October 2012 and September 2013 were sentenced for marijuana-related crimes. As a result of crowded prisons and growing enforcement costs, both houses of Congress have introduced bills that would reduce the length of mandatory prison sentences for some drug crimes. As momentum gathers, we may soon see serious efforts to legalize marijuana at the federal level.

Second hurdle: product economics
Even if marijuana is legalized, it still is unclear if tobacco companies would want to enter the market. High taxes and a robust black market for marijuana will put a lid on profitability. One study found that proposed taxes in Washington would increase the cost of marijuana by 58%.

Even Altria's vast capital resources -- it generated nearly $4.4 billion in operating cash flow in 2013 -- may not provide enough scale to offset high excise taxes and compete with illegitimate operations. Based on a $2 per gram production cost, the above-referenced study estimated that the after-tax retail price of legal marijuana would be $16.99 per gram -- or $482 per ounce. The stunning markup comes after the marijuana is taxed at the producer level, processor level, and retail level.

According to priceofweed.com, which aggregates user-submitted marijuana prices by state, marijuana prices exceed $400 per ounce in only one U.S. state: $401 per ounce for high-end marijuana in North Dakota. The website marks medium-grade marijuana at slightly less than $200 in Colorado and Washington. Altria will be unable to compete with these prices, regardless of the scale of its operations.

Only one way to compete
The only feasible way for Altria, Reynolds American, and Lorillard to compete against lower-priced competitors is to build premium brands that deliver consistent quality. Marijuana comes in all different varieties and potencies; the average consumer of legal marijuana may not want to get a surprise every time he or she inhales a new purchase. Big tobacco companies are in position to provide large-scale, consistent-quality marijuana cigarettes to an American public that wants to take the edge off.

For instance, Altria's Marlboro brand already has a strong following of loyal cigarette smokers. Marlboro has a 43.7% share of the tobacco market. Reynolds' Camel and Pall Mall brands have a combined 17.8% market share. Lorillard's retail market share is nearly 15%, thanks to Newport's 12.6% market share. Although not all tobacco smokers will smoke legal marijuana, those that do may stick to their cigarette brand. So Newport marijuana cigarettes will have an advantage over some upstart brand. This gives tobacco companies a built-in advantage in the nascent market.

Moreover, tobacco companies can leverage their current infrastructure and distribution channels to dominate the marijuana market. Altria lists $4.7 billion in land, machinery, buildings, and equipment on its balance sheet (before depreciation). Reynolds' fixed assets exceed $2.5 billion and Lorillard's cost nearly $800 million. Tobacco companies have already made the huge investments in infrastructure required to manufacture and distribute cigarettes; all they would have to do to enter the marijuana market is change the ingredients. No other group of companies in the U.S. is better-suited to dominate the marijuana market, which is why Altria, Reynolds, and Lorillard can do so if and when it makes sense.  

Bottom line
Do not expect to find Marlboro Ms or Camel Cannabis in convenience stores any time soon. Hurdles involving federal legislation and product economics must be cleared before tobacco companies will enter the marijuana market. With a federal government that is content to allow marijuana experimentation to spread state by state, the first hurdle will not be cleared any time soon. Even then, it could be a decade or more before the black market disappears to allow legitimate operators to earn a decent return on capital. Although it could eventually dominate the market, big tobacco's marijuana fantasy is just a pipe dream for now.

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Read/Post Comments (10) | Recommend This Article (6)

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.

  • Report this Comment On March 29, 2014, at 1:13 PM, SELLmtg wrote:

    My opinion: Buy PMCM ( a mj co. that owns a

    marijuana store and marijuana production facility in

    Seattle, WA (Yahoo.finance, news 3/19, 3/21)

    PMCM=0.0047 (as of 3/28) and will go up higher.

    PMCM can grow marijuana plants in its marijuana

    production facility legally in WA because WA is 1 of the 2 states that legalized marijuana. Buy PMCM.

  • Report this Comment On March 29, 2014, at 5:45 PM, seanfromvt wrote:

    It is my opinion that large tobacco firms are about a situated to take off with the Cannabis market as a soybean or turkey farmer would be. The speculation from this writer shows how out of touch the investment community is if this is what passes off as popular opinion. In my opinion, commercial growers will focus on high yield fast maturing Cannabis Indicas plants which will leave the global market for more Cannabis Sativa in the equatorial regions to boom. The Cannabis industry will provide a huge boost to the entire world once the United States admits its mistake on this special plant.

  • Report this Comment On April 01, 2014, at 5:00 PM, Sue5 wrote:

    This article assumes that everybody is anxious to smoke marijuana legally. Although there are good solid reasons for legalization (such as over-crowded corrupt private prisons), I am always surprised by the popular assumptions that we all wish to partake, not so.

  • Report this Comment On April 02, 2014, at 12:28 AM, Snafubar wrote:

    At almost 500$ an oz? I don't think so. Even 200$ an oz is too much. Okay, not everyone can grow the really good stuff, but let's be real here......the govt will tax it right back to the underground market if they aren't careful.

  • Report this Comment On April 02, 2014, at 10:51 AM, fishlkmich wrote:

    I have never seen such a huge miss. Where is the "Third hurdle"? Anyone who is familiar with this plant knows that the product degrades if you grind up the nice flowers and dry them to a crisp. You end up with a harsh smoke that loses its potency daily. They would have to carry a "freshness stamp" and be rotated faster than milk. Anyone who uses this plant regularly would never be "brand dependent". Variety is part of the enjoyment, like fine wines. We don't want to smoke it, either! Vaporize it. Eat it. Smoking is not medicinal. Recreational users would also prefer anything to smoking this plant. Big pharma will take much more money than big tobacco from pot. There is better medicine in this plant than in your local pharmacy.

  • Report this Comment On April 02, 2014, at 10:55 AM, twcooper wrote:

    Sue5:

    I agree that the majority of Americans will not smoke pot even if it is legalized. Then again, the majority of Americans (more than 80% of adults) do not smoke cigarettes, yet that's an enormously profitable business, taxes and all. The millions who have served time for marijuana-related crimes are evidence of strong demand.

    I still think the biggest risk to the marijuana business is regulation; if taxes are too high and regulation too stringent, the product economics won't make sense. Demand is there on the black market, but the legitimate market won't survive unless the black market is eliminated.

  • Report this Comment On April 02, 2014, at 11:15 AM, herbwarrior420 wrote:

    snafubar where do u buy $500.00 an oz canna-bis???? I have been a legal mmj patient and caregiver for over 14 years. The caregivers I know have ounces of top shelf medical grade bud for $125.00 to $150.00 an ounce. Sue 5 how much are black market ounce prices???? (Excluding mexican brick dirt weed schwagg).

  • Report this Comment On April 02, 2014, at 11:31 AM, Rockyvnvmc wrote:

    As a young man, I had an older fellow employee show me a unopened pack of Camels, with marijuana written on the package. He said it was from before cannabis prohibition.

    Now, I don't know if it was a gag, or if it was the real deal, but it most certainly looked like authentic

    Since I do know, that cannabis was fully legal, in the US prior to the 1930s, it could very well have been authentic. In fact, most people aren't aware of this, but cannabis has been used for about 5000 year, for it's medicinal properties, up until the lying campaign, by various Industry Lobbyists (Timber, Pharmaceutical and Cotton come to mind), of the 30's turned it into a pariah.

    What I can't figure out, is Where the federal Government gets it's, supposed, authority to ban the substance, to begin with. Considering that it's a naturally occurring plant, or herb, I fail to see how any institution of government has claim to the rights to prohibit it's growth or even it's usage.

    After all, it took an Act of Congress to pass Alcohol Prohibition and yet another Act, to repeal it.

    The FDA is nominally in control of all 'drugs', but since cannabis isn't a manufactured 'drug', but a naturally occurring herb, it shouldn't fall under their purview.

  • Report this Comment On April 02, 2014, at 1:36 PM, Joesbox wrote:

    I remember hearing stories about large tobacco companies back in the early 70's getting copy rights to names like Acapulco Gold and Panama Red for future use in marijuana cigarettes, but nothing happened. I personally feel that tobacco companies should not be able to open a market on marijuana because of they would probably add all kinds of chemicals like they do to cigarettes. The quality would suffer and there is a question whether marijuana would suffer the same as tobacco has because of the millions of deaths caused by tobacco use. Marijuana doesn't need any more false stories then it already has.

  • Report this Comment On April 02, 2014, at 2:33 PM, DakotaWoman wrote:

    Who wouldn't want to smoke / sell marijuana Marlboros? Anyone with a properly-working brain and common sense. If it ever becomes legal everywhere, there will be dead bodies around me the first time some idiot lights up in my presence. This crap has a thousands-years' history of causing brain and genetic damage. Why don't you who think this is so good just go where A-Quaida is and hand yourselves over and leave us our healthy atmosphere here. Thanks.

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