In the past decade, the social status of smoking has significantly changed. Now that the negative effects cigarettes have on the health are fully known, the government has been making a bigger effort to reduce the numbers of smokers in the U.S. (with similar state action taking place in other countries). From smoking bans to health campaigning, you may be led to wonder why cigarettes and tobacco products aren't simply made illegal.
There is one very obvious reason why this path has not been pursued: Taxes. The U.S. government makes billions of dollars each year from tax levied on cigarette products, with a $10.07 tax on each carton of cigarettes. I doubt that a blanket ban on smoking will ever be introduced, and so the tobacco industry continues to operate.
It is true that the industry as a whole has faced decline because of the backlash against smoking. With more information out there about the health effects of smoking, people are trying harder to kick the habit and are less likely to start up. But can the same be said for previously established tobacco companies? America's leading provider, Altria (MO), has not seen the decline in company performance you might expect. The company's stock was the best performer in the S&P 500 between 1957 and 2007, and continued to strongly perform even throughout the 2008-2009 recession (with the stock value being reduced in the April of 2008 due to shares in Kraft (KFT) being redistributed to all shareholders).
Looking more carefully at the structure of the industry, it is easy to see how Altria has maintained a strong stock position. The company dominates the market with over half the market share, and this is unlikely to change given high tax levels and the ban on cigarette advertising. it is almost impossible for other companies to compete. Altria isn't a growth company, so lack of advertising does not prevent it from pursuing desired growth. It also doesn't need to pump substantial funds into research and development projects, meaning higher dividends for investors. A high proportion of these dividends are reinvested, pushing Altria's share price up even more. Add to this the fact that as tobacco is an addictive substance, demand for it is relatively inelastic, and it doesn't seem so strange that the monopoly tobacco company is doing so well. Even during the financial crisis and recession, tobacco shares were not hit too hard by the increased volatility. Due to soaring stress levels, people are actually more likely to increase the number of cigarette products they buy in difficult economic times.
This week it has came to light that sales of pipe tobacco have been harming traditional cigarette providers such as Altria. When taxes on cigarette products went up from $3.90 dollars to $10.07, taxes on pipe tobacco went up to only $1.15 from 45 cents. The reasoning behind this was that a higher tax rate would have damaged the already small pipe tobacco industry too much to allow suppliers to continue in the business. But a large number of retailers are using a loophole in legislation to effectively sell cigarette tobacco as pipe tobacco, to avoid the higher tax rate. Consumers have figured this out, and are seeking out these retailers in order to purchase their tobacco at a cheaper price, choosing to 'roll their own' cigarettes.
Altria, with the backing of various U.S. health organizations, is now seeking to raise pipe tobacco tax to the same level as cigarette and cigarette tobacco tax. The company claims that the two products are too similar for such different brackets of taxation. I think the government is likely to take their complaint seriously - it is estimated that since 2009, around $1.3 billion in tax revenue has been lost due to mislabeled pipe tobacco sales. There could therefore soon be significant tax changes to prevent this trend continuing and expanding. This would be great news for Altria, which would likely regain customers that have switched to purchasing pipe tobacco over the past few years.
It will also be good news for competitor Vector (VGR), a company with holdings including the Liggett tobacco group, which has also been campaigning for changes in tax laws. I predict the company can expect its share price to rise as speculation regarding potential tax changes continues. Similar trends will likely be seen in the share prices of tobacco producers Lorillard (LO) and Reynolds American (RAI). But the largest impact is still likely to be seen in the case of Altria, as it dominates such a large proportion of the customer base. The majority of those who switched to purchasing pipe tobacco were previously Altria customers.
But what can be said for the tobacco industry in the long run? I think for the moment, and throughout the coming decade, it will remain steadily prosperous, with investors receiving healthy dividends even with the government push to prevent smoking. Beyond this, things may not be so certain. There is the possibility of a generational effect; figures show that fewer and fewer youngsters today are developing the addictive habit. As they grow up, their children are therefore also less likely to smoke - and in time, the proportion of smokers in the population will significantly drop. Tobacco companies will certainly feel the strain of the advertising ban then. Would the government be likely to drop this, in order to maintain the high tax revenue received from tobacco sales? Probably not - it will be paying out far less in healthcare for smokers, so revenue losses will quickly be balanced out (and most likely exceeded).
That said, my advice now would be to invest, invest, invest in Altria. I feel the share remains slightly below its true value due to many investors rejecting it as a 'socially irresponsible' stock. Whether it is this or not depends on your point of view. Either way, I can see the share price continuing its steady rise throughout the next few years, even if tax changes are slow to be enacted.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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