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China's Proposed Smoking Restriction Will Be a Problem for These Companies

By Rupert Hargreaves – Mar 24, 2014 at 9:04AM

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Philip Morris and Universal are likely to be affected by a Chinese ban on public smoking, but Altria will get off lightly.

China is the final frontier for tobacco companies, one of the few nations worldwide where the consumption of cigarettes is still rising. This is a great opportunity for companies that can access the market, such as Philip Morris International (PM 0.65%) and Universal (UVV 0.99%).

Huge opportunity
According to data supplied by Universal, the world's leading publicly traded supplier of tobacco to the tobacco industry, the volume of cigarettes sold around the world is expected to decline at a compounded annual rate of 0%-1.3% from 2012 to 2015. However, during this same period, the volume of cigarettes sold within China is expected to expand at an annual rate of 1.5%-2.5%.

The Chinese tobacco market is controlled by the Chinese National Tobacco Corp., or CNTC, a state enterprise and monopoly, which collects more than $95 billion in annual revenue for government coffers. As a result, it is particularly hard for outsiders to gain access to China's domestic tobacco market -- the world's largest cigarette market is essentially shut off to outside competition. 

However, Philip Morris has two agreements with the CNTC that are highly beneficial to both companies. In particular, the CNTC is allowed to produce 2 billion units of Marlboro cigarettes per year; in return, Philip Morris partners with the CNTC to sell several "joint venture brands" around the world. Overall, this allows Philip Morris to benefit from Chinese tobacco market growth and leaves the door open for the two companies to sign further distribution and manufacturing agreements in the future.

Meanwhile, Universal counts the CNTC as one of its top three customers, after Philip Morris and Imperial Tobacco. As a result, Universal benefits by selling more tobacco to meet China's rising demand.

Trouble ahead
China, though, recently decided that it's time to take action against the rising numbers of smokers within the country. The government is considering strict rules on smoking in public as it tries to curb surging health care costs.

China's health commission is drafting a proposed national ban on smoking in public locations for all, including senior officials. While the ban has been under consideration for some time, debate has been pushed forward as China was forced to raise its annual health care budget by 27% last year, to 260 billion yuan (roughly $42.5 billion). Smoking is not entirely to blame for that jump in expenditures as the country grapples with a rising number of patients, and a $42.5 billion boost is minuscule for a nation of 1.35 billion people. Nonetheless, rising costs have caused concern, and the government wants to take action before spending gets out of control.

This ban is bound to have an impact on tobacco sales, which would not do Philip Morris and Universal any good. According to Chinese officials, many Chinese people believe laws made by the government are for the benefit of the people and many will comply without question, possibly putting the brakes on the rising number of smokers within the country.

No trouble for Altria
(MO 0.27%) is a pure play on the U.S. domestic tobacco market and is not going to feel the impact of China's smoking ban.

In addition, Altria is more diversified than many of its tobacco sector peers. Specifically, during 2013 Altria's revenue came to a total of $24.6 billion before excise taxes. Of that, $22 billion, or 90%, came from "smokeable" products and $2 billion, or 8%, came from smokeless products. Wine contributed $600 million, or 2% of revenue. Additionally, the company received $1 billion from its investment in global brewing giant SABMiller, which went straight to Altria's bottom line.

Altria looks attractive from a financial metric standpoint as well. The most important of these metrics is the company's impressive dividend history. An investment in the company during the past 10 years would have returned just less than 20% annually if the dividends were reinvested; this is a return you'd be hard pressed to find anywhere else. At present, the company offers a 5.2% yield.

Foolish summary
The Chinese tobacco market is relatively shut off, and a smoking ban within the country is likely to hurt the state tobacco company more than any other company. However, Philip Morris and Universal do have an exposure to the Chinese cigarette market, and they are likely to report an impact on sales if this ban goes ahead.

Rupert Hargreaves owns shares of Universal and Altria. 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.

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