Saturday, March 29, 2008

Big Tobacco Faces Further Cigarette Market Declines In The U.S.

NEW YORK -The future of Big Tobacco in the U.S. is looking hazy.
Tobacco companies have been steadily selling fewer cigarettes in the U.S., but that rate of decline is likely to accelerate over the next few years. Those declines will mean the biggest cigarette companies could be in for a much tougher fight for their survival and growth in the U.S.
Altria Group Inc. (MO) - which at the end of this week will spin off its Philip Morris International business and transform itself into a domestic tobacco company - expects unit volumes of the overall U.S. cigarettes industry to decline by 2.5% to 3% a year for the next few years. That decline is steeper than the historical rate of about 2%. Altria estimates industry volumes, or the number of cigarettes sold, fell about 4% in 2007.
"We have highlighted accelerated volume declines as one of the bigger risks the industry faces," said Janice Hofferber, a vice president at Moody's Investors Service who follows tobacco and consumer products. Historically, tobacco companies have been able to raise prices fairly easily, but "there is a limit to the pricing flexibility these companies have."
The weaker volumes will mean that cigarette companies will need to focus more on cost cuts, and to dabble in new kinds of tobacco products. One thing, however, is unlikely to change: Altria is likely to continue to have the upperhand in U.S. tobacco market for some years due to the power of its Malboro brand.
In general, volumes have declined as cigarettes sellers have been pushed to boost prices to offset higher federal and state taxes and to make annual payments under a 1998 settlement agreement with states. Bans on smoking in public places and more health-conscious consumers have also contributed to the cigarette volume declines.
The U.S. tobacco companies have been trying to grow in the smaller, growing market for smokeless tobacco products. Altria - or the Big MO as the company is often called for its trading symbol - has a relatively small presence so far in smokeless tobacco. But its Marlboro brand still has 41% share of the retail market, larger than the combined share of the next 10 largest cigarette brands. Marlboro also continues to gain market share. Last year, Altria's U.S. tobacco segment saw revenue net of excise taxes rise 1.2% to $15 billion.
"I think Altria is better positioned to withstand price increases because of their brand position," said Hofferber.
Lorillard is in the next best position after Altria, she said, due to its dominance in menthol cigarettes. At the end of last year, Loews Corp. (LTR) announced plans to spin off Lorillard, its tobacco unit. Lorillard's Newport cigarettes are the top selling brand in the menthol market.
Rival Reynolds American Inc. (RAI) made an astute and quick move through its acquisition of smokeless tobacco maker Conwood in 2006 but Conwood by itself isn't sufficient to offset the challenges of weaker cigarette demand. The smokeless tobacco market is still far smaller than the market for cigarettes. A spokesman for Reynolds, which sells brands like Camel and Kool, said the company is making concerted efforts to get adult smokers to switch to its brands by introducing product and packaging innovation.
Cigarettes accounted for more than 90% of expenditures on all tobacco products in the U.S. in 2006, according data compiled by the Center for Disease Control and Prevention. Total spending on tobacco was $88.8 billion in 2005, of which $ 82 billion was spent on cigarettes, according to the agency.
Altria, Reynolds American, and the soon-to-be-independent Lorillard will not be able to rely on international growth to offset U.S. declines. Altria will be a U.S. tobacco company after the March 28 spinoff of Philip Morris International. Reynolds does business mainly in the U.S., while Lorillard sold the international rights to substantially all of its brands, including Newport, in 1977.
That said, some investors are still hoping to see steady returns from U.S. tobacco businesses.
"There is still a lot to like," about cigarette stocks, said Charles Norton, portfolio manager of the $183 million Vice Fund, which owns tobacco industry shares. "The story for the U.S. cigarette makers is not one of volume growth."
Norton likes these companies' strong pricing power, emphasis on cost reduction, their expansion into alternative tobacco products, their willingness to distribute cash to shareholders through dividends or buybacks, and an improved legal environment. In the last couple years, cigarette companies have had several important legal victories in tobacco lawsuits in the U.S.
"Tobacco in general offers earnings stability and dividend security that are vital in uncertain times like we are experiencing right now," Norton said. Norton's fund holds shares of Altria and Carolina Group (CG), currently the tracking stock for Lorillard. He has short positions in smokeless tobacco company UST Inc. (UST) and Reynolds American.
So far, no one is predicting the death of the U.S cigarette industry. Standard & Poor's tobacco debt analyst Ken Shea said, "You are going to have a universe of consumers" for cigarettes.