Traditionally, Big Tobacco companies are considered to be some of market's most defensive stocks what with their robust cash flows, high profit margins, and cunning management teams. In particular, based on the percentage of sales converted to free cash flow, Philip Morris (NYSE:PM) is the most cash-generative company in the world, while peers British American Tobacco (NYSEMKT:BTI) and Imperial Tobacco (NASDAQOTH:ITYBY) are the fourth and ninth most cash generative companies in the world, respectively.
But with the number of smokers on the decline around the world, many investors have started to ask if this profitability is sustainable -- and it would appear that for the time being it is. Here's why.
A taxing problem
One of the biggest issues that has weighed on Big Tobacco in recent years is the rising amount of excise taxes companies have been forced to pay on 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 Imperial's bottom line.
We can quite clearly see the effect of these taxes on Philip Morris' profit and shareholder returns. In 2013, for example, Philip Morris' revenue totaled $80 billion and the company's cost of sales was only $10.4 billion, giving a gross margin of 87%. But excise taxes for the year amounted to $49 billion and after including both excise taxes and the cost of goods sold, Philip Morris' gross margin fell to only 26%.
Nevertheless, although these taxes are taking 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 it.
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.
Philip Morris in particular is also set to benefit from excise tax reform currently under way within the Philippines.
Up until 2013 the Philippines government placed an excise tax on cigarettes based on the net retail price per pack. Anything under 11.50 Philippine pesos, PHP for short, was taxed at 2.72 PHP per pack and any packet of cigarettes with a retail price above 11.50 was taxed at 12 PHP per pack, an unfair method of taxation.
Now, this method of taxation is being reformed. The Philippines government began to revamp its tax regime during 2013 and this will continue until 2017. The reforms include an increase in the rate of tax on all cigarettes to a standard 30 PHP per pack. As a result, over the long term Philip Morris' management believes that the company will actually benefit, even though its sales are taking a hit in the short term.
To understand why Philip Morris will benefit, we have to take a look at the Philippines tobacco market, particularly at Philip Morris' main competitor in the market, Mighty Corporation. According to Philip Morris, going by official tax statistics and Nielsen baseline data, Mighty declared to the Bureau of Internal Revenue less than half the volume of cigarettes that it sold in 2013. This gave Mighty the ability to maintain artificially low prices for its brands, which kept the rate of tax applied down. By establishing a set rate of taxation across all cigarette types the ruling should remove Mighty's ability to maintain artificially low prices and the price gap should close, which will put Philip Morris back in the game.
And finally, one of the movements that is really going to help Big Tobacco over the next few years is diversification into the smokeless or reduced risk section of the tobacco market.
For a start, Philip Morris recently signed an agreement with U.S. peer. Altria whereby the two companies will share the technology for electronic cigarettes, or e-cigs, and "reduced-risk" products under several licensing, supply, and cooperation agreements. Reduced-risk products are, according to Philip Morris, products that reduce the risk of tobacco-related illnesses.
The company recently invested €500 million in a reduced-risk product-manufacturing facility in Italy, ahead of a full commercialization of one of its reduced-risk products in the second half of 2014. According to Philip Morris, once fully operational, the factory's annual production capacity is expected to reach up to 30 billion units by 2016.
In addition, both British American and Imperial tobacco have developed their own e-cig products. Actually, Imperial owns Dragonite, a company founded by Hon Lik, who is credited with the invention of the e-cig and many of the technologies associated with it. As a result, Dragonite and Lik hold the rights and ownership over an "extensive portfolio" of global patents and pending patents covering e-cig technologies -- of course, Imperial now owns these rights and has made a stir by suing many peers using the technology.
Overall, although the number of smokers is sliding around the world, Big Tobacco companies are using a number of strategies to increase profits and sales. These initiatives should ensure that Big Tobacco maintains its crown as the most profitable industry around.
Rupert Hargreaves 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.