Please ensure Javascript is enabled for purposes of website accessibility

Is China a Dead-End for Cigarette Stocks?

By Glenn Singewald – Mar 6, 2014 at 7:00PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

China leads big tobacco’s growth prospects for Asia. But could a recent study, China’s Michelle Obama, and a state-run economy spell dead-end for investors?

Big tobacco companies like Philip Morris International (PM -0.95%), British American Tobacco (BTI -0.40%), and Reynolds American (RAI) would love to crack China.

While the tobacco industry sputters in developed countries due to regulation and health issues, the opposite story unfolds in developing nations: rising incomes and populations are driving positive growth for global tobacco companies. And yet China remains walled.

Without China, home to 40% of the global smoking population at 300 million smokers, big tobacco companies will be hard-pressed to generate impressive profits in the long term. What follows are major challenges to big tobacco's aims for China...and a glimmer of hope.

Brand competition
Before tobacco conglomerates can profit off China's lungs, they must infiltrate its markets.

That's harder than getting a camel through the eye of a needle: right now, state-owned China National Tobacco Company commands a near-monopoly, with 98% market share. In 2005, Philip Morris allied with CNTC to access China's 600 million tarred lungs. Philip Morris signed a 10-year contract for CNTC to distribute Philip Morris' iconic Marlboro cigarettes.

Though that strategic move no doubt induced jealousy in British American Tobacco and Reynolds American, Philip Morris' bottom line hardly benefited from the partnership. As of 2012, Marlboro had a dismal 0.3% market share in China. Adding insult to paltry profit, Chinese smokers have apparently been puffing counterfeit Marlboros since before 2005.

Tough government
For the Foolish sake of argument, let's assume that Philip Morris, British American Tobacco, Reynolds American, and all big-tobacco companies gain full access to China. In 36 years, will China's market offer attractive growth for big-tobacco companies?

Maybe not, considering that China is trying to ash its nasty habit. Just as Michelle Obama campaigns against childhood obesity, China's first lady, Peng Liyuan, denounces smoking. She even partnered with Bill Gates in an anti-smoking demonstration. China's government seems to be following Liyuan's lead, as indicated by its December decree to ban officials from publicly smoking.

If China's government makes serious moves to curb smoking, it could spell a slow death for big tobacco's growth hopes. A new report issued by British Medical Journal indicates that by 2050, China could reduce smoking by 40% using specified public-health interventions.

Glimmers of hope
Then again, China's government may not hasten to dismantle its tobacco industry before Philip Morris, British American, and R.J. Reynolds have a chance to capture smokers.

Death and taxes: China's cigarette industry links life's two inevitabilities together. In 2011, China's government received $96 billion in revenue from tobacco. China's coffers may be as addicted to tobacco as its citizens, with tobacco bringing 7%-10% of government revenue.

That means if tobacco multinationals can find a way to increase China's tobacco potential, they may be greedily beckoned through its Great Wall. Philip Morris gets China's money motive: "Why would they share their market? To come up with new [tobacco] technology is really the only avenue to get into a place like China," noted Philip Morris' chief executive last June.

To that end, big tobacco's facing an innovation arms race for products like e-cigarettes. Whether these products will be enough to pique China's economic interest remains hazy.

Foolish bottom line
Facing closed doors at every turn, big-tobacco companies like Philip Morris, British American Tobacco, and Reynolds American could benefit greatly from China's monolithic market. Yet they face barriers like China's state-owned tobacco monopoly and an increasingly anti-smoking government. Philip Morris leads the panting pack with market access and innovation insights.

Glenn Singewald has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. 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.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.