The Tobacco companies, including Philip Morris (PM +0.99%), Altria (MO 1.11%) and Lorillard (LO +0.00%), are facing volume growth challenges because of regulations and increasing health awareness among consumers. Tobacco companies have been relying on price increases to support top and bottom line growths, as sales volumes are on the decline. In the first quarter of 2014, Philip Morris, Altria and Lorillard experienced YoY sales volumes decline of 2%, 3.5% and 1.8%, respectively.
Despite the challenges, Philip Morris, the world's leading tobacco company, has done well to maintain its market dominance. Also, the company has done well to expand its earnings per share and dividends; in the last three years, it has experienced EPS and dividend growths of 10.2% and 13.6%, respectively. The company's long-term fundamental outlook looks solid, as it has been making investments to strengthen its product portfolio, address challenges in key markets and protect its market share. Altria and Lorillard are also making investments to strengthen and diversify their product portfolios, mainly focusing on smokeless segments, as sales volumes of conventional cigarettes are on the decline.
Bright spot
The European Union region remains an important market for Philip Morris, as it contributes almost one-third of the company's consolidated operating income. In the past, Philip Morris had struggled to deliver satisfactory performance in the EU; however, it seems things there have recently started to turn in its favor. In the first quarter of 2014, operating income in the EU region for Philip Morris increased by 4.3% year-over-year to $978 million in the first quarter of 2014. Also in the quarter, sales volume dropped by only 2.9% for Philip Morris in the region, better than the average industry sales volume decline of 5.9%.
In another positive takeaway from the first-quarter results, the company's market share in the EU region increased by 0.90 basis points to 38.9%. Investors could see this as an early sign of an improvement in the region's operating environment. Also, the EU has increased its focus on the prevention of illicit trade and this likely augurs well for industry volumes and the performance of the company in the future.
Short-term challenges
The Asia region, which offers growth potential due to a growing population and increasing income, has been an important market for Philip Morris. Asia contributes almost 30% of the company's consolidated operating income. Asia has historically been important for the company's profit growth; however, in the recent past, the operating environment has been challenging in some key Asian markets, including Japan and Indonesia. The challenges are likely to be short lived, as the company has been making investments to address the challenges and strengthen its volume market share.
Japan is an important market and offers attractive long-term profit potential for Philip Morris. However, in the short term, the company faces competitive pressures in Japan. In the first quarter of 2014, Philip Morris' market share in Japan was 25.5%, down 2% YoY, mainly because of Japan Tobacco's (JAPAF +0.00%) successful efforts to regain its market share after the 2011 earthquake.
Philip Morris is efficiently trying to counter the pressure on its market share in Japan by accelerating investment, mainly in innovation, modernization of products, and brand building. The company's 'Be Marlboro' campaign', which it initiated in the first quarter of 2014 in Japan, has received a positive response at the consumer level. The efforts undertaken by Philip Morris in Japan to strengthen its performance are likely to put pressure on the company's margins in the short term; however, they will help the company stabilize its market share and return to growth in the long term.
The company is also experiencing softness in Indonesia and the Philippines. Both markets are important for Philip Morris in the long term, but will likely prove challenging for Philip Morris in the short term. In Indonesia the company is facing growing competition from small-scale cigarette makers, who benefited from tax reforms. The company saw its market share drop 110 bps QoQ to 34.6% in the first quarter of 2014. In the long term, the company is likely to stabilize its market share as a result of its brand-building investment.
The company has made price support moves in the Philippines to protect its market share in response to an aggressive excise tax increase in the first quarter of 2013 and this will likely adversely impact its profits in the short term, but once the company stabilizes its market share and volumes, it can focus on profitability growth.
Product portfolio diversification
The challenges faced by the tobacco industry in growing sales volume have forced Philip Morris, Altria and Lorillard to ramp up investments to support their market shares and strengthen and diversify their product portfolios. The investments by the tobacco companies are likely to put short-term pressure on their earnings, but augur well for long-term performance. Phillip Morris will probably spend $100 million on Next Generation Products in 2014.
Altria and Lorillard are also investing to protect their market shares and diversify their product portfolios. Altria has been focused on promoting its smokeless and alternate tobacco products (e-cigs). Altria made a strategic acquisition of Green Smoke earlier this quarter to increase its presence in the e-cigs market. Also, Altria plans for a national roll-out of its e-cig brand, Mark-Ten, by the end of the current second quarter. In the recent past, Lorillard has also made the strategic acquisitions of Blu e-cigs and SKYCIG to create a strong e-cigs portfolio. Lorillard has a dominant e-cigs market share of 45% in the U.S. Now, Lorillard is rolling out its Blu e-cigs in the U.K. this summer, which will help it expand its presence in the global e-cigs market.
Final take
Philip Morris has a dominant market share in the global tobacco market and has been making efforts to protect and further improve it. The company's performance in the EU region in the recent quarter was a positive takeaway and investors could see it as the beginning of operating environment improvement. The company does face short-term challenges in Asia, but it has been undertaking constructive actions there, including brand-building investments, to protect its market share and these bode well in terms of its long-term market share and profitability. However, in the short term, the company's profits are likely to remain under pressure due to its brand-building efforts.
