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Are tobacco companies' days numbered? Value investors have long embraced them as consumer staples that are more or less recession proof, but the trickle of regulation governing where you can smoke, and how much those smokes are taxed, has turned into a flood. Yet the big three American firms have managed to increase their profits through price increases, and with Altria announcing that it has decided to follow its two main competitors by entering the market for electronic cigarettes, the prognosis is better than it seems at first blush.
The dip in cigarette volumes reported during Reynolds Holdings' first-quarter earnings on Tuesday startled the sector, as investors began to suspect that authorities' efforts to shock the public into quitting were beginning to work. Now that Altria and Lorillard have also reported, it's clear that they have: the 3- to 4-per-cent annual decline in cigarette sales volumes has begun to steepen, with major U.S. producers reporting first-quarter year over year declines of 6.2 per cent. And regulators have no intention of slowing down. Just this week New York began considering a proposal to raise the minimum age for buying cigarettes from 18 to 21.
Yet Altria and Lorillard's stocks are back up, indicating that investors' dissatisfaction was specifically with Reynolds, which had been losing market share. The other two are better regarded: Lorillard's brighter prospects can be partly attributed to its Blu eCigs line of electronic cigarettes, whose sales leapt from $39-million (U.S.) in the fourth quarter of 2012 to $57-million in the next. E-cigarettes have been gaining ground astonishingly quickly; on Friday the Wall Street Journal reported that e-cigarette sales in the U.S. totaled $500-million in 2012, and that according to Euromonitor, they were expected to reach $1-billion in 2013. Altria is now getting in on the game, announcing its intention to launch its own e-cigarettes line later this year.
By strategically raising prices in tandem with tax increases, big tobacco has managed to mitigate the impact of declining sales volumes while the industry pins its future hopes on e-cigarettes, whose proponents say that the odourless nicotine-vaporizing devices are less harmful to users than traditional cigarettes. That transition might not go smoothly: there is significant regulatory risk from the Food and Drug Administration, which has announced its intention in the near future to regulate e-cigarettes and also cigars – both of which are largely exempt from cigarette taxes, a status that could change depending on how the FDA handles the issue. There's also the question of the tobacco companies' ability to attract new customers, e-cigarettes or no.
But the companies are not especially expensive by price-to-earnings ratio standards, and with a potential growth story replacing the otherwise well-worn cultural narrative that people are shifting away from smoking, the outlook for the tobacco industry is looking significantly less risky than it did a few years ago. Even without smoke, there may yet be fire.