Tobacco: Today's Taboo Could Be Tomorrow's ESG
Don't tell me about the economics — I know they're great. You make a product for a penny, you sell it for a dollar, and you sell it to addicts. And it has tremendous brand loyalty.
— Warren Buffett, quoted in Buffett: The Making of an American Capitalism by Rodger Lowenstein
Tobacco is taboo, and that's why tobacco stocks are perennially cheap. But low valuations have only increased returns for owners. Altria is one of the best-performing stocks of all time. $10,000 invested on January 1, 1962, would be worth $135 million today with dividends reinvested. That's a 17% compound annual return for 59 years.
Even more impressive? That's against a headwind of declining unit volumes. U.S. cigarette consumption peaked in 1981 and has fallen 44% since. Naysayers have long forecast that the industry is on the precipice of a tipping point where additional price increases would result in a sharp decrease in demand. The data tells a different story — more on that later.
Though traditional tobacco is alive and well, tobacco companies are trying to disrupt themselves. New products, like heat-not-burn tobacco, e-vapor, cannabis, and oral nicotine pouches, have hit the market in recent years. Health organizations around the world, including the FDA, have concluded that some of these are 90%+ less risky than cigarettes. If these products are the future, will big tobacco shed its stigma?
In this post, I'll discuss Altria and Philip Morris, two of the world's largest tobacco companies. They used to be the same company but split up in 2009. Altria took the U.S. business, Philip Morris, everything else. They share the same brand portfolio, and Altria has an exclusive license to sell Philip Morris's IQOS in the U.S.
Regardless of how you feel about tobacco, the industry's phenomenal economics are worth studying. Investing is all about pattern recognition, and understanding why tobacco companies are so profitable might illuminate similar situations elsewhere.
Competitive Position
Tobacco's performance is the result of a strong competitive position and low valuations. In our Fall 2020 Letter, we discussed tobacco's competitive position using Professor's Michael Porter's "Five Forces" framework.
1. Bargaining Power of Customers — Despite the known health risks, humans love tobacco. Consumption dates back over 5,000 years. For many, tobacco is an affordable luxury that offers a momentary escape. Nicotine's addictiveness makes consumers insensitive to price increases. Altria raises prices a few percent twice per year. Pricing power is the most valuable business quality because it produces growth without any cost: an infinite return on investment. U.S. cigarette consumption has dropped 44% since 1981, but pricing power has propelled Altria's stock 71,000% higher since then.
2. Bargaining Power of Suppliers — Tobacco leaf is the most expensive ingredient in a cigarette. Since many farmers produce suitable tobacco, Altria can shop for the lowest price. The best businesses buy commodities, like tobacco, and sell brands, like Marlboro.
3. Threat of New Entrants — The U.S. government banned T.V. and radio advertising in 1971 and all other forms in 1998. That entrenched the incumbent's market share. New entrants no longer have the means to build a brand, which is a strong deterrent.
4. Threat of Substitute Products — New nicotine-delivery mechanisms have recently emerged and could threaten Altria's cigarette business. These include e-vapor products like JUUL and heat-not-burn tobacco products like IQOS. Fortunately, Altria is hedged. It owns 35% of JUUL and the U.S. rights to IQOS. No matter where consumer preferences drift, Altria will be there.
5. Intensity of Competitive Rivalry —Tobacco is now an oligopoly. The few remaining firms compete rationally. They raise prices in tandem, which avoids price wars and protects margins.
Low Valuations Produce High Yields
As a result of their strong competitive position, tobacco companies gush cash. They return most profits to shareholders as dividends. Altria pays out 80% of earnings and has increased its dividend 53 times in the past 50 years. That's a record few have approached.
Even so, tobacco companies generally trade at below-average valuations. Altria and Philip Morris trade for 10x and 15x earnings today, well below the market's 21x median. Low valuations and high payouts make for high dividend yields. Altria and Philip Morris yield 8% and 6%.
Low valuations are great for shareholders because they provide a high rate of return on reinvested dividends. If Altria traded at the market’s median multiple of 22x, its dividend yield would fall from above 8% to below 4%. Over 20 years, an 8% reinvestment rate will produce twice as much capital as a 4% rate. Investors who expect to be net purchasers of businesses should pray valuations fall, not rise.
A stock's total return will approximate its growth plus yield. A high dividend yield means investors don't need much growth to earn a high total return. But, tobacco companies do grow. Price increases more than offset volumes declines.
Tobacco companies are "capital-light compounders" because they can grow while returning virtually all profits to owners. Few businesses can grow without capital, making capital-light compounders scarce. Tobacco companies manage to grow without capital by raising prices.
Tipping Point
Cigarette demand is inelastic. Higher prices hardly reduce demand. Some investors fear prices are near a tipping point and that demand will become more elastic. This thesis gained credence in 2019 when Altria reported cigarette volumes fell 7%.
As it turns out, this was a temporary response to e-vapor. When the FDA clamped down on vaping, smokers switched back to cigarettes. Last year Altria's volumes only fell 0.4%.
Australia shows where the tipping point might lie. Between 2011 and 2017, the Australian government raised taxes enough to double the retail price of cigarettes.
A pack in Australia now costs $25, well above the U.S.'s $6.30. As a result, the smoking rate fell from 16% to 13%. There were also significant trade downs from premium to discount brands.
If the tipping point is $25 per pack, Altria and Philip Morris have a long runway ahead. Assuming 2% inflation and 4% real price increases, they won't hit $25 per pack until 2045. Even then, the Australian business slowed but hasn't died.
Another way to measure Altria's pricing headroom is to calculate prices in terms of minutes of labor. By that metric, the U.S. is the fourth most affordable among the 35 OECD nations. Altria should be able to offset volume declines with price increases for decades to come.
The tobacco market is more stable than many realize. 19% of the world's population smoke, consuming 5.2 trillion cigarettes annually. The World Health Organization estimates that there are 1.1 billion smokers worldwide. In five years, they expect the same amount.
The corollary? Regulatory measures designed to curb smoking are not accelerating cessation.
Reduced Risk Products (RRPs)
If regulations are the stick, RRPs might be the carrot. RRP stands for reduced-risk products and includes e-vapor, like JUUL, and heat-not-burn tobacco, like IQOS. Philip Morris has led the innovation. They've invested $8 billion over the last decade and are now beginning to see the fruits of their labor.
Philip Morris believes their future is smokeless. That's what's best for its customers and public health. It's also best for themselves. RRPs are even more profitable than cigarettes. Win-win-win.
Philip Morris's RRP devices are branded IQOS, pronounced eye-kose. Philip Morris claims it doesn't stand for anything, but rumors abound that it's an acronym for "I quit original smoking." Regardless, Philip Morris plans to use IQOS to disrupt and cannibalize itself.
There aren't many businesses sitting on a cash cow actively trying to kill it. American Express did when it issued credit cards that competed with its Travelers Checks. And Netflix did it when it offered streaming that competed with its mail delivery business. Both seemed crazy at the time and genius now. Could Philip Morris be on the same track?
Early evidence looks promising. Already 25% of Philip Morris's revenues come from RRPs. They want 50% of their revenue to come from RRPs by 2025.
IQOS
IQOS follows a razor/razor-blade model. Devices sell at a slight loss, and profits come from consumables. Heated tobacco units, or HTUs, are the consumables. They look like cigarettes and carry brand names like Marlboro and Parliament. Taste is indistinguishable from cigarettes, making transitioning seamless.
The main reason to switch is to reduce risk. We all know cigarettes are harmful. But why exactly? Many think the problem is nicotine. In reality, it is combustion.
Nicotine is addictive but doesn't cause disease. Combustion produces tar and harmful chemicals known as HPHCs. Tar and HPHCs cause disease. Any smoke, whether from a campfire, cigarette, or cannabis, contains HPHCs.
IQOS avoids combustion by heating tobacco from the inside out and aerosolizing it. It delivers the tobacco's flavor and nicotine with significantly fewer HPHCs.
The FDA found that IQOS poses less risk to users than cigarettes. On July 7, 2020, the FDA authorized Altria to market IQOS 2.4 and three related consumables as a "modified risk tobacco product." Specifically, they approved this language:
AVAILABLE EVIDENCE TO DATE:
- The IQOS system heats tobacco but does not burn it.
- This significantly reduces the production of harmful and potentially harmful chemicals.
- Scientific studies have shown that switching completely from conventional cigarettes to the IQOS system significantly reduces your body's exposure to harmful or potentially harmful chemicals.
In May 2018, the German Federal Institute for Risk Assessment ("BfR") published a study finding that IQOS reduced 80-99% of HPHCs. In June 2018, the Korean Food and Drug Administration ("KFDA") likewise found that IQOS produced 90% fewer HPHCs than cigarettes.
The question I'm grappling with is, how harmful is IQOS on an absolute basis? I understand it's 90%+ less harmful than cigarettes, but that's not saying much. Is IQOS like playing Russian Roulette with one bullet instead of two? Or does it pose health risks on par with regularly eating McDonald's or a nightly glass of wine?
Economics of RRPs
RRPs are better for consumers, public health, and Philip Morris's bottom line.
Most jurisdictions tax heat-not-burn tobacco less than cigarettes. So, Philip Morris can price HTUs below cigarettes and still reap more revenue per pack. Net revenue per pack of HTUs is 2.4x higher than cigarettes, and the gross margin is ten percentage points higher at 75%. Consumers still save money, providing a monetary incentive to switch. Win-win.
Philip Morris aims to sell 140-160 billion HTUs in 2023 and has already built enough manufacturing capacity to do it. Adding capacity to manufacture 10 billion more HTUs will cost $150 million. When sold, 10 billion HTUs will increase gross profits by $525 million. That's after accounting for the cigarettes cannibalized. Spending $150 to make $525 gross is a high incremental return on capital.
As Philip Morris scales IQOS, it will also experience operating leverage. SG&A will increase absolutely but decrease as a percent of sales. Philip Morris has already built most of the SG&A infrastructure it will need. It is finding that its incremental investments have a payback period of less than a year in most markets.
IQOS also has the potential to increase volumes. Unlike cigarettes, HTUs don't stink. If smokers didn't have to smoke outside, I'd bet they'd smoke more.
The downside of RRPs could be lower brand loyalty. So far, consumers treat RRPs more like beer than cigarettes. Beer drinkers rotate between brands, while smokers stay loyal to one. Fragmented use makes scale harder to achieve. RRPs' higher prices and margins will help offset this headwind.
Then again, current behavior might be temporary experimentation. Two summers ago, we saw this in the "seltzer wars." LaCroix sales weakened as brands entered the market at discounted prices to take share. After a year or so, consumers had tried all the new brands and decided they liked LaCroix best. Sales bounced back. The same might be happening today in the RRP space.
Another issue is with the razor/razor blade model. Consumers may try to use generic HTUs in an IQOS device. The latest device, IQOS ILUMA, has a remedy. It senses a metal coil inside the HTU and automatically heats by induction. Only Philip Morris's HTUs will trigger the sensor.
Regulation
Regulation is the most significant uncertainty facing tobacco and RRPs.
Governments around the world have taken measures to dissuade smokers from smoking. These include plain packaging, large warning labels, and high taxes. And yet, 19% of the world — 1.1 billion people — continue to smoke. Draconian anti-smoking measures have hardly made a dent in cessation rates.
RRPs might be able to make a bigger impact. RRPs reduce risk but don't eliminate it. Switching to RRPs is not as beneficial as quitting. But, quitting isn't realistic for most. If governments banned cigarettes tomorrow, a thriving black market would erupt overnight. That's not in anyone's best interest.
Philip Morris compares RRPs to electric vehicles (E.V.s). E.V.s still harm the environment, but less than combustion engines. Governments have decided E.V.s are a step in the right direction and created tax incentives to switch. Philip Morris wants governments to do the same with RRPs.
Since 2009 the FDA has regulated tobacco in the U.S. That was actually Altria's idea. Today, that's both a blessing and a curse.
It's a blessing because the U.S. has a regulatory body capable of analyzing the science behind RRPs. Most countries do not.
It's a curse because the FDA took two years to review IQOS. While under review, IQOS sat on the sidelines in the U.S. Meanwhile, e-vapor companies took the country by storm and created an underage vaping epidemic. Overseas, IQOS got millions to quit smoking while the FDA deliberated.
In the long run, the FDA's rigor will benefit American's health. Any tobacco products sold today must receive a PMTA from the FDA. PMTA stands for pre-market tobacco authorization. The PMTA process is a lot like how the FDA approves new pharmaceuticals. Tobacco companies must conduct scientific studies and submit their results. British American Tobacco said their PMTA submission for glo ran to 150,000 pages.
PMTAs create a barrier to entry and favor incumbents like Altria. Altria has decades of experience working with the FDA. This institutional know-how was hard-won and isn't trivial. Further, Altria has the scale to justify spending upfront time and money on product trials. Startups might not be able to front the cost and uncertainty of a PMTA submission.
One risk of FDA regulation is that the FDA has unilateral power to do whatever it wants. They’ve discusses banning menthol cigarettes for years. So far, it’s been all bark and no bite. They’ve also discussed limiting the nicotine content of cigarettes. However, this could backfire. Consumers might buy more cigarettes to get the same amount of nicotine.
Capital Allocation
Capital allocation has been good at Philip Morris and bad at Altria. These businesses are strong enough to withstand a little mismanagement. Buffett says to buy a business that even a ham sandwich could run because eventually, one will.
Former Altria CEO Howard Willard was a ham sandwich. He paid $12.8 billion for 35% of JUUL, a whopping 40x sales, and 150x EBITDA. Months before, JUUL had been valued at less than half that. As often happens when paying for growth, it didn't materialize. Altria has written JUUL down to $1.7 billion.
Around the same time, Altria also acquired a 45% stake in Cronos, a Canadian cannabis company. Though this hasn't yielded any profits yet, Cronos's stock has at least held up around Altria's cost. If the federal government legalizes cannabis, Altria will be ready.
Howard Willard has since left Altria. I think the board learned their lesson and won't be approving an acquisition anytime soon.
Dividends are the cornerstone of capital allocation at both companies. Altria targets an 80% payout, while Philip Morris targets 75%.
Besides dividends, Altria buys back about a billion dollars of stock a year, adding about 1% to its yield. Philip Morris hasn't made any repurchases recently. They've signaled that they will approve a $5-7 billion buyback if their RRPs are on-track later this year. They've promised to be opportunistic about prices.
Forward Returns
Altria and Philip Morris's cigarette businesses more than justify their current prices. The tipping point is decades out. In the interim, dividends provide a floor to long-term returns. 2-3% volume declines paired with inflation plus 4% pricing should produce mid-single-digit growth.
Both companies should be able to return 80-90% of net income via dividends and repurchases. Altria and Philip Morris currently yield 8% and 6%. Adding another percent for buybacks and 5% for growth gets us to 12-14% returns.
That's before considering RRPs, which are accretive to sales and margins. Today IQOS is only available in Atlanta and Richmond. It won't move the needle for Altria until it's available nationally. Philip Morris expects RRPs to drive high single-digit growth.
Altria and Philip Morris are above-average businesses at below-average prices. They trade for 10x and 15x earnings, respectively. If RRPs catch on, the tobacco taboo may finally lift. Non-cyclical, growing consumer staples usually trade at premium valuations. WD-40 trades for an astounding 57x earning! I wouldn't count on Altria or Philip Morris fetching anything close to that valuation. But, there's plenty of room for multiples to expand if ESG investors decide to jump on board in the decade ahead.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.