Source: Flickr user Marlus Mellebye.
To put it succinctly, the tobacco industry is in flux.
On one hand, tobacco is a highly addictive substance that, almost regardless of pricing, seems to keep bringing smokers back for more. Despite the number of adult smokers in the United States falling from more than 40% in the mid-1960s to 18.1% of all U.S. adults (42.1 million) as of 2012, tobacco companies like Altria and Reynolds American (RAI +0.00%) have seen their stock prices soar by roughly 160% over the trailing five years. This is partly to do with an improving U.S. economy, but superior pricing power, related to the addictive nature of tobacco, has been important in driving consistent profitability.
Yet, the war on tobacco is kicking into high gear. In 2012, the Centers for Disease Control and Prevention spent $54 million (arguably a small amount) on a multi-channel anti-smoking campaign, the agencies' first foray into public advertising regarding the dangers of smoking.
Why would the CDC take such an aggressive stance on smoking? According to CDC statistics, smoking causes approximately 480,000 deaths each year and accounts for $289 billion in direct and indirect costs. As a follow-up in 2013, the CDC noted that 1.6 million adults took action by trying to quit smoking because of the CDC's ad campaign, with an estimated 100,000 expected to quit permanently.
In response, tobacco companies have had to field a number of inquiries into the composition of their cigarettes (e.g., chemical composition), as well as introduce products deemed to be safer, such as electronic cigarettes that release a vapor as opposed to tobacco smoke. Lorillard (LO +0.00%), which is actually in the process of being acquired by Reynolds American, owns the Blu e-cigarette brand, which currently holds the bulk of e-cigarette market share in the U.S.
But, one tobacco company is making a head-scratching move that you'd probably never expect in response to public and regulatory pressure.
Source: Flickr user Qfamily.
This is the last thing you'd expect a tobacco company to do
Earlier this month, Reynolds American announced, via an Associated Press news release, that it planned to take its Zonnic nicotine gum nationwide. Zonnic was acquired when Reynolds American purchased Niconovum in 2009.
Think about this for a moment: One of the nation's largest cigarette makers is intentionally beefing up the distribution of a gum used to aid smokers in their efforts to quit. In other words, this move could cannibalize its primary product.
Confused yet?
In actuality, it might be a genius move on Reynolds American's part if it plays its cards right.
This could be a smart move
Overall, the global nicotine replacement market generates about $2.4 billion in annual sales. The U.S. is responsible for close to 40% of this $2.4 billion. Compared to Reynolds American's forecasted 2014 revenue of $8.4 billion, this might seem like chicken scratch, but it gives the company a number of ways to boost sales.
First, by offering smokers a way to quit, Reynolds American can possibly improve its image with the public. Anti-smoking advertisements often cast tobacco companies as the bad guy, so taking the approach of distributing its nicotine gum throughout the country could be viewed positively by certain groups and individuals, ultimately helping capture nicotine replacement market share, and perhaps even improving brand loyalty.
Source: Flickr user Serge Melkl.
Secondly, tobacco companies have shown that they can essentially keep revenue near the flat line by boosting the price of cigarettes despite a somewhat steady decline in total cigarette sales. What this means for a company like Reynolds American, which has excellent pricing power, is that it can actually boost sales without thoroughly cannibalizing its cigarette volume by diversifying its product offerings to include nicotine gum.
Finally, and perhaps the most interesting aspect of this move, is what might happen to the pharmaceutical market, which makes products designed to help people stop smoking. Pfizer's (PFE +0.57%) Chantix and GlaxoSmithKline's (GSK 1.03%) Zyban (which is also used to treat depression under the brand name Wellbutrin) are two commonly prescribed drugs used to help people stop smoking.
My initial reaction to this move is that Reynolds American may be looking to push smokers away from pharmaceutical products in order to ensure that it captures significant nicotine replacement market share. That could be modestly bad news for Pfizer, as Chantix accounted for $343 million in U.S. sales last year. GlaxoSmithKline, on the other hand, only tallied roughly $26 million in full-year sales from Wellbutrin last year, so Reynolds American's aggressive push into anti-smoking aids probably won't be a big hit to its business. Even Pfizer shareholders shouldn't worry too much as Chantix's total U.S. sales equate to just 0.66% of Pfizer's total revenue last year.
Diversifying its product offerings
With the inclusion of Lorillard, Reynolds American could soon become the clear tobacco leader to contend with. In addition to excellent pricing power, and Lorillard's premium Newport brand, which has been a key reason Lorillard's market share has grown in each of the past 11 years, Reynolds' top market share in electronic cigarettes, and perhaps a sizable portion of the nicotine replacement market, could make it one of the more balanced vice companies investors have ever seen.
Of course, it still remains to be seen how successful Reynolds American's integration with Lorillard will be, or how well Zonnic will sell across the country. But, consider yourself on notice as an investor that the tobacco industry is rapidly changing, and those companies that remain static could be left in the dust.
