Is the U.S. Cigarette Industry Going Up in Smoke?

It has been a difficult year so far for the domestic tobacco firms, which have struggled to balance the retail price of cigarettes with the economic trends affecting many of their core customers. We've been concerned for much of the last year that cigarettes were starting to reach price points at which demand could start to falter, so we weren't too surprised to see volumes decline for all of the domestic manufacturers during the first quarter of 2008. The magnitude of the decline, however, when combined with the economic forces we face today and the potential for increased regulation and excise taxes in the year ahead, has led us to lower our near- and long-term expectations for all three of the U.S. cigarette manufacturers-- Philip Morris USA/Altria (MO),  Reynolds American , and  Lorillard/Carolina Group .

A Primer on Tobacco Stocks
Domestic tobacco stocks tend to respond to three main drivers: litigation, industry fundamentals, and changes in the political or regulatory environment. Although the litigation environment has improved substantially during the last five years, leading to a dramatic runup in the shares of Altria (up more than 50%), Reynolds American (200%), and Carolina Group (150%), the specter of multi-billion-dollar lawsuits or settlements has not completely gone away. And even though the main participants in the domestic tobacco industry believed they had scored a coup in 1998 when they signed the Master Trust Settlement (MSA), agreeing to pay around $10 billion annually to the 50 states in order to settle all of the Medicaid-related lawsuits the states were launching, it has also limited the ability of the cigarette manufacturers to take pricing beyond a certain level.

In the months leading up to the signing of the agreement, the domestic cigarette manufacturers took small price increases in order to cover the cost of prior settlements, and then initiated a large one-time step-up in the price of a pack of cigarettes in order to overcome the expense burden of the MSA. As such, the average price for a pack of cigarettes at the start of 1999 was 75% higher than it had been at the end of 1997. Since then, manufacturers have used price increases to offset declining volume trends, with the wholesale price of a pack of cigarettes rising another 65% during the last nine years (to $2.70 per pack). To manage the volume declines that came with the higher prices, as well as to ward off competition from deep discount offerings, manufacturers have to rely more heavily on promotions, buy-downs, and other discounts.

Although raising prices to fund the expense of paying out billions of dollars annually to the states might have seemed like a good idea at the time, it has created several long-term issues for the cigarette manufacturers. Rather than sacrificing profit margins, the industry decided to expense the annual cost of its settlement payments as part of its cost of goods sold, raising prices just enough to maintain operating profits longer term. This, in essence, created a fixed cost that has proven difficult to manage, especially given the declining volume trends that the industry has been facing. It also doesn't help that the industry's pricing power has been hindered somewhat by the dramatic increases seen in state and local excise taxes during the last 10 years.

At this point, the amount being set aside by each of the top three domestic cigarette firms is equivalent to about one third of their annual net sales (which excludes the impact of federal excise taxes). It also makes up more than two thirds of cost of goods sold, limiting the ability of the cigarette manufacturers to improve their gross margins significantly longer term.

Top 3 U.S. Cigarette Manufacturers 2007 Revenues and Cost of Goods Sold
	Philip Morris USA  (MO)	Reynolds American	Carolina Group
Reported Revenues	18,485 mil		11,049 mil		3,969 mil
Less: Excise Taxes	3,452	(18.7%)	2,026	(18.3%)	688	(17.3%)
Net Sales (ex. Federal Excise Tax)	$15,033 mil		$9,023 mil		$3,281 mil
Cost of Goods Sold	7,827	(52.1%)	4,960	(55.0%)	1,619	(49.3%)
Actual Cost of Goods Sold	2,327	(15.5%)	2,160	(23.9%)	569	(17.3%)
Master Settlement Agreement	5,500	(36.6%)	2,800	(31.0%)	1,050	(32.0%)
(MSA / Cost of Goods Sold)		5/7		4/7		2/3
Gross Profit	$7,206	(47.9%)	$4,063	(45.0%)	$1,662	(50.7%)
* Morningstar estimates based on publicly released information.

While there are differences in the makeup of cost of goods sold among the top three manufacturers--such as the fact that Reynolds and Carolina Group make adjustments to their annual MSA payments to account for prior year's market share losses, while Philip Morris USA (PMUSA) does not--it is likely that only Reynolds has the ability to improve its gross margins by narrowing the gap that exists between itself and its peers. But given the fact that Reynolds generates far less in sales from premium brands (which have higher profit margins) than either PMUSA or Carolina Group, it will take more than just manufacturing improvements to augment the company's gross margins.

Cigarette Pricing Is Critical, Complex
Pricing has become an extremely important tool for the domestic cigarette manufacturers. Because a 1-percentage-point increase in pricing has more than twice the impact on operating profits as a 1-percentage-point increase in volumes, it is important for the U.S. cigarette producers to have a firm control on the retail price of their products. Unfortunately, by the very nature of how cigarettes are distributed and sold, manufacturers tend to lose a significant amount of control over pricing once the product leaves their warehouses. Once manufactured, cigarettes are sold to wholesalers who in turn sell them to retailers, who are the main point of purchase for most smokers. Before the product even leaves the manufacturer, though, the federal government gets its cut (via a $0.39-per-pack federal excise tax), which the tobacco firms build into the wholesale price--along with the tariff they assess to cover the billions of dollars paid out annually to the states as part of the MSA.

At this point, the price of a pack of cigarettes is around $2.70. Once wholesalers take delivery of the product, they add their own markup and then pass it along to retailers, which add their own trade margin to the price. By this point a pack of cigarettes costs around $3.35 nationwide. Some distributors and retailers demand somewhat higher compensation for their services as middlemen in the cigarette sales chain, with markups running well over $1.00 per pack in places such as Alaska, Hawaii, Illinois, and New York.

As if this weren't bad enough, state and local governments have also tapped into the money stream by levying their own taxes on cigarettes. This raises the average price at which a pack of cigarettes is sold in the United States to around $4.65. Many state and local governments are far more demanding than others, which explains why cigarettes sell for more than $8.00 a pack in places such as Chicago and New York City and for less than $4.00 a pack in some areas of Florida and Georgia.

This not only serves to undermine one of the prevailing arguments that emerged in the aftermath of the signing of the MSA, which was that the states were effectively "in bed" with big tobacco and would not allow the industry to falter, but also shows how much the states have come to rely on the revenue generated by the cigarette industry. Despite the fact that most states cashed out of the annuitylike stream of payments from the cigarette producers in the early years of the settlement by floating municipal bonds that provided a lump-sum payout, many continue to come back to the industry when they need money to plug their own budget deficits. As such, we think the states have come to treat the tobacco firms as the gravy train that never ends, putting their own interest well ahead of the long-term health of the industry.

Even more troubling for the industry is the fact that the federal government is considering raising the federal excise tax from $0.39 to $1.00 per pack in order to increase funding for the State Children's Health Insurance Program. Although the proposal might be dead in the water right now, we believe the dynamics of the upcoming national elections could shift the balance of power in Washington enough to where raising the federal excise tax could be just the first step of a wave of changes for the domestic tobacco firms--which could ultimately include regulation of the industry by the Food and Drug Administration.

An Industry in Decline
With all of that in mind, we felt it necessary to reassess the ability of the industry to keep taking price increases in the face of a difficult macroeconomic environment where higher state and federal taxes on cigarette sales are much more likely than they were even just a few months ago. Although we believe that manufacturers have some influence over the price that wholesalers and retailers charge (through the use of trade promotions and other discounts), they have relatively little control over the impact that cigarette taxes have on retail prices. This ultimately limits the ability of tobacco firms to take price increases in markets where excise taxes have already driven the price of a pack of cigarettes much higher than what consumers might be willing to bear. This not only affects urban markets such as Chicago or New York City where cigarettes are selling for $8-$10 a pack, but also small rural markets in the South where the rising costs of food and fuel have severely affected the amount of disposable income left for smokers to spend on tobacco products.

The bigger, long-term problem for all three companies is that the industry itself is in secular decline. The prevalence of cigarette smoking has decreased during the last 50 years as the American public has increasingly been made aware of the dangers associated with the habit. This has reduced the number of smokers in the U.S. from nearly half the adult population in the 1950s to roughly one in five today. Sales peaked at around 640 billion sticks (or 32 billion packs of cigarettes) in 1981, with volume declining around 2.5% per year ever since. Although the rate of decline has been closer to 3.2% per year since the MSA was signed in 1998, it had actually been trending lower (to about 3.0% annually) during the course of the last five years. That all changed this year, as first-quarter volumes declined 4%-5%. The industry now expects that rate to hold for the remainder of 2008.

% Change in U.S. Cigarette Volumes
	Total Industry	Philip Morris USA (MO)	Reynolds American	Carolina Group
5-Year CAGR 1991-1995	-1.3%	0.1%	0.2%	-0.6%
5-Year CAGR 1996-2000	-2.9%	-0.9%	-7.1%	0.9%
5-Year CAGR 2001-2005	-2.8%	-2.6%	-5.9%	-2.7%
10-Year CAGR 1991-2000	-2.1%	-0.4%	-3.5%	0.2%
10-Year CAGR 1996-2005	-2.9%	-1.8%	-6.5%	-0.9%
10-Year CAGR 1998-2007*	-3.2%	-2.9%	-6.8%	-1.4%
15-Year CAGR 1991-2005	-2.3%	-1.1%	-4.3%	-0.8%
* Highlights volume declines experienced in 10 years following signing of the MSA by the major domestic cigarette firms.

Morningstar's Take on Future Trends
Given the impact that rising sales taxes traditionally have on volumes, as well as our concerns about the impact that a slowing economy will have on consumption trends, we've revised our long-term volume growth expectations for the industry from negative 2%-3% per year to annual declines of 3%-4%. With the economy likely in recession and food and fuel expenditures taking up a larger and larger portion of consumer spending, we expect industry volumes to decline at a slightly greater rate in both 2008 and 2009. With only limited pricing power going forward, we now envision a much different sales and profitability environment for the industry than we did even just a few short months ago.

Of the three domestic cigarette producers we cover, we expect Reynolds to be affected the most, as the company has effectively bet the farm on the success of its three top brands--Camel, Kool, and Pall Mall. With no brand support behind its discount offerings (which still make up nearly 40% of the firm's cigarette portfolio), and its two main competitors turning to heavier levels of promotional spending in the premium category, Reynolds has found itself stuck in the middle--unable to take on either battle without sacrificing a significant portion of the gains it has made in operating profitability.

We expect Lorillard/Carolina Group to also feel the pinch, as both Reynolds and PMUSA have raised the stakes in the menthol category, forcing the company to be far more promotional than it would like to be. Volumes have held up so far, but sales and profitability have taken a hit and could potentially trend down further if the company needs to get more aggressive with its competitors. Although Newport is still the top-selling menthol brand in the U.S., and the second-largest cigarette brand overall, Lorillard may find it difficult to defend its top brand with both Reynolds and PMUSA putting so much effort into increasing sales in the menthol category.

As for PMUSA/Altria, we believe that its fortunes rise and fall with Marlboro. Accounting for 42% of the total domestic cigarette market, and 82% of PMUSA's annual cigarette sales, the brand has fared far better than most in light of the hurdles the industry currently faces. As the market leader, PMUSA dictates pricing for the industry and so far has taken the promotional route to maintain its market share. Although the company can certainly afford to be more aggressive than its peers, a prolonged bout of promotional spending by the industry would ultimately serve to limit many of the top- and bottom-line gains that we're expecting from Altria longer term.