Australia Ashes Philip Morris: What's Next?

Philip Morris sent two alarming signals this month about the state of Big Tobacco as it announced factory closures in Australia and the Netherlands. As developed nations heighten their regulations and smoking rates decline, can Big Tobacco continue to cough up profits and dividends?

Apr 11, 2014 at 11:30AM

Australia and Europe ashed Philip Morris International (NYSE:PM) earlier this month. Thanks to increasingly draconian regulations, the cigarette conglomerate was forced to close plants in Australia and the Netherlands. Investors must get savvy to the latest regulations threatening Philip Morris and Big Tobacco, and whether Big Tobacco can maintain a $700 billion global industry.

Brandless packages
Philip Morris blamed the closure of its Australian factory on the Aussie government's tobacco-export restrictions. These led to Philip Morris's factory being "significantly under-utilized, operating at less than half of its currently installed capacity," according to the company. Since Australia was the first locale outside the United States where Philip Morris expanded almost 60 years ago, the shutdown of Philip Morris' Melbourne factory comes as a landmark moment in the tale of Big Tobacco.

Another Australian regulation that doubtless harmed Philip Morris was a 2012 law which required the sale of tobacco in logo-less, dark brown packaging. Despite Big Tobacco's million-dollar lobbying efforts, the law passed and it appears effective. The Australian government hopes to curb smoking rates from 16% to less than 10% by 2018. That can't bode well for Philip Morris' profits.

Lamenting menthols
Big Tobacco must have lamented the recently announced closure of Philip Morris' Netherlands factory. Philip Morris cited a 2013 European Union regulation, which required larger warning labels and a ban on flavored cigarettes like menthols, as contributing to a 20% sales decline over four years. Philip Morris issued a bearish prognosis as it deemed a revenue recovery in the Netherlands "highly unlikely."

Across the pond in America, Lorillard (NYSE:LO) leads the U.S. flavored-cigarette market. Lorillard gets 90% of its sales from menthol cigarettes, including its salient Newport brand. As the Food and Drug Administration considers banning menthol cigarettes, Lorillard waits with bated smoker's breath. Given that 40% of youth smokers have tried menthols, the FDA and anti-smoking groups view Lorillard's flavored cigarettes as enticing a fresh generation of tobacco addicts.

Developing markets
As they face regulatory headaches across developed continents like Australia, Europe, and America, Big Tobacco companies like Philip Morris and Lorillard seek un-smoked growth frontiers. These days, developing markets that include Southeast Asia and Africa are Big Tobacco's Promised Land. That helps explain Philip Morris' plan to move its former Australian factory to South Korea. However, as these markets develop they will likely also regulate tobacco.

Where should Big Tobacco turn, stuck between regulations in developed nations and time-limited opportunities in developing nations? The industry's silver bullet may be the e-cigarette. Lorillard has been aggressive in advancing this technology-enabled smokeless cigarette, as it acquired British e-cig vendor Skycig for $50 million in 2013. Yet even innovative e-cigarettes may not escape the regulatory forces that have squeezed Big Tobacco's profits for several decades.

Major cities like Chicago, Los Angeles, and New York are already clamping down on e-cigs. They've banned smoking e-cigarettes in public places, regulating e-cigs just like cigarettes.

Foolish bottom line
Early April has been rough for Big Tobacco with Philip Morris shutting down factories in Europe and Australia and partly blaming government regulations. As the FDA debates whether to ban menthol cigarettes in America, Big Tobacco brands like Lorillard are in jeopardy. Philip Morris and Lorillard's fates hang on how much longer developing markets and e-cigarettes will evade tobacco regulation. Current and potential investors should evaluate whether these dividend-paying stocks will crumble under regulation, or innovate their way toward growth again.

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Glenn Singewald 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.

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