Although most tobacco companies raise prices twice a year -- once in the spring and again in the fall -- Altria (MO +1.95%) has taken the rare action of raising cigarette prices for a third time.
While the first two price hikes were seen as a bullish sign at the time because they showed tobacco companies could offset declining shipments with higher prices almost at will, they also suggested tobacco markets are much weaker than some might believe -- meaning it may not have been the sign of strength it was perceived to be. Altria's earnings last week show both views are true.
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A captive audience
Beyond the health issues associated with smoking, cigarette companies are well-known for their pricing power. The addictive qualities of nicotine cause smokers to pay almost any price to get their fix, the revenue from which is used to support the lush dividends the tobacco giants pay.
Governments understand this, too, which is why cigarette taxes are routinely increased when politicians want to pay for their spending programs. They say they're levying them on the tobacco companies, but they're just passed along to smokers in the form of per-pack price increases that are willingly paid.
Altria's price hikes were not related to any tax increases, but rather its own disappointing earnings results. Analysts were still awed by Altria's flex.
Data source: Altria and Securities and Exchange Commission filings.
A new norm?
This third increase came just before Altria released its third-quarter results. Shipment volume declines once again were worse than the industry's. But the price hike also came as the company was under immense pressure from regulators for its investment in leading electronic cigarette maker Juul Labs and the possibility of nicotine in cigarettes being dramatically reduced by the Food and Drug Administration to near-nonexistent levels.
Three price hikes a year could become the new norm because Altria may be foreseeing a mass exodus of smokers from cigarettes. It could use its pricing power to shepherd them to new channels, with the higher prices also blunting the shrinking volumes that will follow.
Restructuring the industry
The e-cig industry may not survive in its current form because of FDA regulations. Facing a looming May 2020 deadline to submit applications to keep their products on the market, small e-cig makers may not have the financial wherewithal to make it over the hurdle, leaving users with few alternatives.
There's also substantial doubt Juul Labs will make it through to the end. Altria just wrote off $4.5 billion of its $12.8 billion investment in the e-cig leader, and more write-offs could be on the way.
If cigarette manufacturers are also forced to reduce nicotine levels in cigarettes to nearly nothing, smokers could very well seek out other means of getting their fix, which makes the arrival in the U.S. of Philip Morris International's IQOS heated tobacco device most opportune.
A more expensive future
The IQOS uses real tobacco heated to the point of creating a vapor to deliver both nicotine and the flavor smokers miss when they use other e-cig devices. Having already received FDA approval, Altria, which is marketing and selling the IQOS in the U.S. under the Marlboro name, could help smokers migrate to the device by regularly raising the price of its cigarettes.
The price hikes would also have the benefit of mitigating the additional loss in volumes that would follow from the imposition of any draconian nicotine rules.
Analysts are right that raising prices three times in a year shows just how powerful Altria's industry position is, though it also underscores the risks the company faces. In risk there could be reward, however, and if the tobacco giant adopts a policy of three price hikes a year, it could reap substantial profits to drive its dividend payments higher.
