1 Huge Threat to Tobacco Dividends Just Emerged Out of the UK

What would happen to Philip Morris (PM 0.31%) and Altria Group (MO 1.14%) if cigarettes were banned outright? Utter destruction! British lawmakers are being pressured to consider a permanent ban on cigarette smoking after an influential group of doctors voted on a plan to phase out the tobacco products. If they enact it, cigarette companies could see their customers evaporate year-by-year starting in 2019. The rule would have devastating consequences for the tobacco industry, but it may be too early to ditch Philip Morris and Altria just yet.

The law would be disastrous for tobacco companies
The British Medical Association voted last month to lobby for a ban on sales of cigarettes to anyone born after 2000. UK lawmakers previously enacted legislation that banned smoking in public and in cars with children after being lobbied by the British Medical Association. If the doctors' union succeeds again -- and if the idea spreads to other Western nations -- the consequences would be disastrous for tobacco companies.

Historically, Altria and Philip Morris have increased their earnings even as the smoking rate declined. Both companies' premium brands, led by Marlboro, enable them to raise prices to offset declining sales. Last year, Altria's smokeable products earnings increased 4.5% even though the company sold 4% fewer cigarettes than it did in the prior year. Philip Morris' income increased 3.4% in 2013 while its cigarette volume decreased 5.1%.

However, a ban on sales to people born after 2000 would have a huge impact on cigarette sales starting in 2019 -- when those born in 2001 become eligible to smoke in many countries.

Since smokers tend to start young and either quit or die as they age, younger generations have higher smoking rates. According to the Centers for Disease Control and Prevention, 17% of Americans aged 18 to 24 years and 22% of those aged 25 to 44 years smoke cigarettes. The smoking rate declines thereafter.

Source: Centers for Disease Control and Prevention

The pattern also holds in the European Union, although there the smoking rate is much higher. Nearly 40% of EU men aged 20-44 years smoke cigarettes, and the rate falls to 33% for men aged 45 to 64 years.

Since nearly all smokers start before the age of 25, the British Medical Association's plan would drastically increase the rate of decline of legal cigarette smoking wherever legislators enact it. Instead of mid-single-digit annual declines in cigarette volumes, the tobacco industry could be facing 8% to 10% annual declines. At that pace, the smoking rate would be cut in half by 2027 -- too drastic a decline for even Marlboro to offset. As a result, the dividends of Philip Morris and Altria would be in big trouble -- and their high debt loads could even force restructuring.

Probability of occurring
It should be clear that the British Medical Association's plan would be devastating for shareholders in Philip Morris and Altria. It's less clear how likely lawmakers in the UK and elsewhere will be to enact legislation based on the doctors' proposal.

The only precedent for a complete ban on cigarette sales comes from Bhutan, a small kingdom in the Himalayas. The country implemented a ban in 2010, but has since amended the law to allow for limited, heavily taxed tobacco imports following a public outcry. No such precedent exists for the law proposed in the UK, but a gradual ban on cigarette sales may be more palatable than Bhutan's complete ban.

However, indebted European governments and fiscally unbalanced US states may think twice before eliminating such a lucrative source of tax revenue. Last year, Philip Morris paid nearly $50 billion in excise taxes around the world, most of which were due to cigarette sales. Altria paid close to $7 billion in excise taxes.

Moreover, various business groups may lobby for a different tack. Aside from tobacco companies, convenience stores are the businesses that depend the most on cigarette sales. According to the National Association of Convenience Stores, cigarettes account for 37% of revenue for convenience stores and 17% of their gross profit. Convenience store operators -- and other businesses that sell cigarettes -- may have to reduce their headcount to compensate for profits lost from declining cigarette sales, increasing unemployment at a time when jobless rates remain high in many parts of the world.

If nothing else, governments may wait for their own budgets to get back in order before taking down the cigarette market once and for all. Until then, many jurisdictions may prefer a slower decline in the smoking rate, even if it is hard to admit it.

What's an investor to do?
The British Medical Association's plan to phase out cigarette consumption by increasing the legal smoking age each year would devastate Philip Morris and Altria if Western nations enacted it. However, high levels of government indebtedness and the threat to convenience-store jobs may put the proposal on the back burner for now.

Investors should wait to see if the UK enacts the law, gauge its popularity among the electorate, and listen for similar proposals in other countries before they abandon tobacco stocks. However, if the measure gains steam in Europe and the US, shareholders in Philip Morris and Altria should run for the hills.