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Tobacco is Still an Extremely Profitable Business, and This Won't Change Soon

Tobacco is one of the world's most profitable industries. For example, the US' three leading tobacco companies -- Altria (NYSE: MO  ) , Reynolds American (NYSE: RAI  ) , and Lorillard (NYSE: LO.DL  )  -- reported an average net profit margin of approximately 18% for full-year 2013. As a quick comparison, according to the Commerce Department, U.S. corporations currently report an average profit margin of 9.3%. The average margin since 1952 has been 5.9%.

As the number of smokers within the United States continues to decline, many investors would be right to question the sustainability of these tobacco companies' margins. However, current data suggests that smoking is still a huge part of the U.S. consumer landscape and that the habit is not going to die out anytime soon.

Numbers reveal trends
According to data supplied by Altria, cigarettes were the largest consumer market by sales within the U.S. in 2013. In particular, the U.S. cigarette market was worth a total of $66 billion last year, double the size of the beer and cider market, which was worth $30 billion, and three times the size of the $20 billion market for salty snacks.

The dollar value of cigarette sales through major retail channels rose at a compounded annual rate of 7.3% between 2009 and 2013. In comparison, dollar sales of beer and salty snacks only expanded 3.2% and 4%, respectively.

Still, some sections of the tobacco market are doing better than others. From 2010 to 2013, the total volume of cigarettes sold within the US declined at a compounded annual rate of 3.5%. However, the sales volume of machine-made large cigars expanded by 3% per annum, while smokeless tobacco product volume expanded by 5% per annum.

What's more, consumers shift their buying habits to cheaper tobacco products in times of economic uncertainty, hardship, and rising excise taxes.

Consumers are seeking value
Data supplied by Reynolds shows the scale of this "down-trading." The company noted in a recent shareholder presentation that since 2006, the number of premium-brand cigarettes sold as a percentage of the overall volume of cigarettes sold within the United States has declined from slightly more than 70% to only 58.6%. Meanwhile, the value segment has expanded from nearly 30% to 41.4% of the total market.

Reflected in results
This trend is actually reflected within the results of tobacco companies. Let's take Altria as an example; with slightly more than a 50% share of the U.S. domestic tobacco market, Altria is a bellwether for the whole domestic cigarette sector. Based on full-year 2013 results, the stick volume of cigarettes shipped by Altria fell by 4.1% in total. That drop was led by a 4.3% decline in the volume of Marlboro cigarettes shipped and a 10.5% decline in the volume of other premium-branded cigarettes shipped.

In comparison, the volume of L&M discount cigarettes shipped by Altria actually increased by 3.1% for the period, which mitigated some of the declines in other product categories. With value-brand growth, Altria's retail share of the discount-cigarette market hit 4% in the fourth quarter of 2013, up from 3.7% at the end of 2012.

Lorillard's results show a different trend, however. Sales of Lorillard's value-branded cigarettes dropped by roughly 6% for full-year 2013, while the volume of its premium Kent and True cigarettes slumped approximately 12% year over year. These declines accelerated in the fourth quarter to 19%.

Overall, the volume of cigarettes shipped by Lorillard last year actually expanded by 0.5% thanks to a 0.7% increase in the number of Newport-branded cigarettes sold. Newport is by far Lorillard's best-selling brand, with 33 billion units sold during 2013. The company's second best-selling brand Maverick only sold 5.2 billion units for the period.  

The volume of cigarettes shipped by Reynolds during the year slipped 6.8%, a decline that outstripped the industry average. The company's sales of value-branded cigarettes also slumped faster than the industry average at 7.1%.

Foolish summary
It certainly appears the cigarette and wider tobacco market is still very much alive within the U.S. and not going anywhere soon, despite the falling numbers of smokers. Thus tobacco companies should be able to maintain their above-average profit margins for some time yet.

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Rupert Hargreaves

Rupert has been writing for the Motley Fool since December 2012. He primarily covers tobacco and resource companies with a passion for value-oriented investments. .

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