Altria Group (NYSE:MO) is a highly profitable company with significant competitive advantages, but industrywide trends threaten to derail its profitability in 2014 and beyond. The same trends threaten Reynolds American (NYSE:RAI) and Lorillard (NYSE:LO) as well.
A shrinking user base
It is no secret that tobacco use is on the decline in the United States. Most smokers start the habit before turning 18, but the number of high-school-age Americans who smoke has fallen by more than 55% since the mid-1990s. In 2013, fewer than 10% of eighth-, 10th-, and 12th-graders smoked cigarettes -- an all-time low. Moreover, the number of young adults who smoke fell from nearly 1 in 4 in 2005 to fewer than 1 in 5 in 2011. The declining rate of teen and young adult smokers signals that cigarette companies' user base will continue to shrink in the decades ahead.
Not only is Altria's customer base declining, but those who do smoke are smoking fewer cigarettes. In 2013, 9.1% of daily users smoked more than 30 cigarettes per day -- down from 12.6% in 2005. At the same time, the percentage of daily users who smoke fewer than 10 cigarettes increased 5.6 percentage points to 22% in 2011. The evidence suggests that high-frequency users now smoke less frequently.
Few businesses can thrive amid a shrinking customer base that buys a product less frequently as the years go by. Altria, Reynolds American, and Lorillard must address this issue sooner rather than later.
Rising excise taxes
Government regulation has solidified Altria's, Reynolds American's, and Lorillard's market-leading positions by restricting advertising -- making it difficult for smaller brands to gain market share. However, government actions have done far more to hurt, rather than help, big tobacco.
The most devastating aspect of government intervention is the excise taxes imposed on cigarette sales. President Obama signed a $0.62 per-pack federal tax hike in April 2009 -- instantly raising cigarette prices by 22%. The result of the massive tax increase was exactly what the government wanted: $30 billion in additional tax revenue and 3 million fewer smokers since the policy was enacted.
The bright side, for cigarette manufacturers, is that carton prices have historically risen faster than excise taxes. In 1970, taxes made up 47% of the cost of a pack of cigarettes. In 2011, the tax was only 42% of the cost per pack. Pricing power has enabled the leading brands, like Altria and Reynolds American, to maintain profitability despite falling sales volume.
However, pricing power only goes so far. Rising prices have spurred a vibrant black market for cigarettes, leading to further deterioration in cigarette companies' customer base. According to the Financial Times, black-market volume increased nearly two-thirds in 2012. The underground market is so extensive that some smokers believe black-market brands are legitimate. In essence, legitimate tobacco companies like Altria, Reynolds American, and Lorillard must compete against unregulated competitors -- and the competition with black-market brands will only increase as regulators impose higher excise taxes on cigarettes.
Marlboro Friday 2.0
Marlboro Friday is cemented in business lore as the day branding lost its edge. It was the April day in 1993 when Philip Morris announced a 20% price cut to its leading brand, Marlboro, in response to declining market share. It is alarming that generic cigarettes could steal customers from one of the world's most-recognized brands, but it happened. The price cut helped the company regain lost market share, but the lesson is clear: Customers will flee even the best brand if the price rises too high.
Thriving black-market channels combined with less-frequent smoking by a shrinking pool of smokers is a recipe for declining demand for the best brands. If excise taxes are raised much higher, cigarette manufacturers may not be able to raise prices as quickly -- thus reducing profit margins. Shrinking sales volume combined with narrowing profit margins is a recipe for disaster.
Altria, Reynolds American, and Lorillard are hugely profitable companies in an industry that is under attack from all sides. It is up to investors to determine how much of an impact declining tobacco use, higher taxes, and thriving black markets will have on cigarette companies' bottom lines.
Fool contributor Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.