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Will 2Q16 Fare Reasonably Well for Tobacco Companies?

Tobacco Companies Saw Mixed Revenue Results in 1Q16

Highlights of 1Q16 results

Tobacco companies’ results for 1Q16 sent mixed signals to investors. While Philip Morris International (PM) started the earnings season on a disappointing note with lower sales, Altria Group (MO) and Vector Group (VGR) exceeded Wall Street analysts’ revenue expectations in the quarter.

Reynolds American (RAI) missed analysts’ 1Q16 sales estimates, reporting lower-than-expected sales growth.


Factors that impacted 1Q16 revenue

Philip Morris’s reported revenue excluding excise taxes fell by 8.1% to $6.1 billion in 1Q16. Its reported revenue was negatively impacted by $0.7 billion worth of unfavorable foreign currency. However, excluding the adverse impact of foreign currency, PM’s net revenue rose by 2.4% in 1Q16.

Altria’s reported revenue net of excise taxes rose by 6.0% to $4.5 billion in 1Q16. The rise was primarily due to a rise in the revenues of all Altria’s business segments, including smokeable products, smokeless products, and the wine business.

Though Reynolds American missed analysts’ estimates in 1Q16, its reported revenue rose by 41.8% to $2.9 billion in 1Q16 compared to $2.1 billion in 1Q15. This rise was primarily due to Reynolds’s increased cigarette volume of 34.2% in 1Q16, largely driven by its addition of the Newport brand.

Vector Group’s pro forma adjusted revenue rose by 5.4% to $0.38 billion in 1Q16 compared to $0.36 billion in 1Q15. This was primarily due to a rise of $27 million in revenue in its real estate segment.

Innovative e-cigarettes

The tobacco industry’s concentration increased following RAI’s acquisition of Lorillard and RAI’s asset sale of Santa Fe to Japan Tobacco (JAPAF) (JAPAY). Companies are now capitalizing on innovative e-cigarettes to increase their revenues, causing them to shift away from traditional cigarettes.

In the next part of the series, we’ll discuss how acquisitions have highly concentrated the tobacco industry.

MO, PM, and RAI together make up 2.2% of the iShares Core U.S. Growth ETF (IUSG).1

Updated as of July 5, 2016

Could Acquisitions Mean Opportunities for the Tobacco Industry?

As we discussed earlier, the US tobacco industry is highly concentrated Its three leading players accounted for a combined retail (XRT) volume share of 86% in 2014.

The industry’s concentration further increased after Reynolds American (RAI) completed its acquisition of Lorillard and related divestitures to Imperial Tobacco (ITYBY) in July 2015.


Pre-merger, Reynolds and Lorillard were the second- and third-largest US cigarette makers after industry leader Altria Group (MO), which sells the Marlboro brand in the United States. With its acquisition of Lorillard, RAI’s brands broadened their audience.

Divestiture resulted in market opportunities

Reynolds American’s brand divestitures and other developments in 2015 also resulted in new market opportunities for Vector Group’s (VGR) Liggett.

According to an FTC (Federal Trade Commission) complaint, without RAI’s divestiture to ITYBY, its proposed merger with Lorillard would have raised significant competitive concerns, eliminating current and emergent head-to-head competition between Reynolds and Lorillard in the US market for traditional combustible cigarettes.

It would have been difficult for any new entrants to counter the anticompetitive effects of the merger in an already concentrated industry, given players such as Philip Morris International (PM) and Japan Tobacco (JAPAF) (JAPAY), who have presences outside the United States.

Rapidly evolving marketplace

British American Tobacco (BTI) signed a vapor products technology-sharing agreement with RAI on December 1, 2015, to efficiently meet the preferences of adult tobacco consumers in a rapidly evolving marketplace.

On September 29, 2015, Japan Tobacco bought Natural American Spirit’s international assets from Reynolds American in an all-cash transaction valued at ~$5 billion. Santa Fe’s Natural American Spirit, backed by Japan Tobacco Group’s international distribution, sales force, and manufacturing facilities, will accelerate RAI’s growth trajectory and help JAPAF to increase its international portfolio.

PM and RAI together make up 1.4% of the iShares S&P 500 Growth ETF (IVW).1

Updated as of July 5, 2016

Why Tobacco Companies Are Shifting to Innovative Products

Negative CAGR of 3%

Due to increased health consciousness, most of the tobacco companies’ 1Q16 cigarette shipment volumes have seen falls. As developing countries mature, smokers within these countries tend to become more aware of the health risks related to cigarette smoking.

Retail (XRT) volume sales of cigarettes are projected to see a negative CAGR (compound annual growth rate) of 3% throughout the remainder of 2016.


Smokers shift to innovative products

The rise in health consciousness poses a growing threat to the tobacco industry as a whole. Many smokers have turned to cigarette alternatives that they perceive to be cheaper and less harmful to health. Hence, companies are heavily investing in moist snuff, e-cigarettes, and other innovative products to meet consumer expectations, shifting the trend away from traditional cigarettes.

For example, according to Philip Morris International’s (PM) chief financial officer Jacek Olczak, after conducting the clinical tests for iQOS, the company determined that the average reductions in biomarkers of exposure for adult smokers who switched to iQOS reached over 60% in February.

Vuse ranked at the top

Reynolds American’s (RAI) Vuse Digital Vapor Cigarette continued to deliver robust results in 1Q16. According to CEO Susan Cameron, Vuse was ranked at the top of 2015’s most successful new products in convenience stores by IRI. Also, Reynolds rolled out two more variants of Vuse online: VUSE Connect and VUSE FOB.

Altria Group (MO), Japan Tobacco (JAPAF) (JAPAY), and Imperial Tobacco Group (ITYBY) also have presences in smokeless tobacco products. Marlboro Snus (MO), Skruf Snus (JAPAF), and Zerostyle Mint (ITYBY) are some of their smokeless tobacco product brands.

MO and PM together make up 1.3% of the iShares Russell 3000 ETF (IWV).1

Updated as of July 5, 2016

Analyzing Tobacco Companies’ 1Q16 Inventory Levels

Distribution channels

Reynolds American (RAI) and Altria Group (MO) distribute cigarettes through a combination of direct wholesale deliveries from local distribution centers and public warehouses located throughout the United States.

In comparison, peers Philip Morris International (PM), British American Tobacco (BTI), and Japan Tobacco (JAPAF) (JAPAY) distribute their products in many diverse geographies.


Lower inventory levels

1Q16 inventory levels were lower for tobacco companies due to falling cigarette shipment volumes. The inventory turnover ratio for Philip Morris International fell by 10.2% to 1.1x in 1Q16 compared to 1.3x in 1Q15. The ratio was heavily impacted by Indonesia’s soft economy and price increases in Asia. PM’s total market share in Asia fell by 1.3 points to 34.1%, primarily due to a share loss in machine-made kretek cigarettes.

Altria Group’s 1Q16 ended with a 3.5% fall in inventory levels. Its 1Q16 inventory turnover metric came in at 3.7x. However, Altria’s subsidiary Philip Morris USA reported a rise of 1.2% in shipment volumes in 1Q16. This was due to an extra shipping day, trade inventory movements, and retail share gains, which more than offset industry volume decline.

Japan Tobacco’s 1Q16 inventory level fell by ~12% to 1.7x. However, its global flagship brands’ shipment volumes rose by 10.7% to 66.4 billion, driven by European demand and the addition of Reynolds American’s (RAI) Natural American Spirit brand.

Improved economic factors

In comparison, the inventory turnover ratio for Reynolds American rose by 2.5% to 3.4x. This was partly driven by improved economic factors and lower gas prices, which benefited tobacco consumers’ disposable income. In terms of inventory management, Vector Group (VGR) outperformed its peers with a higher inventory turnover ratio of 7.1x in 1Q16.

The iShares Core High Dividend ETF (HDV) gives exposure to established, high-quality US companies including MO and PM. Together, these two stocks make up 8.5% of the total weight of HDV’s portfolio.1

Updated as of July 5, 2016

How Did Tobacco Companies’ Operating Margins Perform in 1Q16?

Mixed margin signals

The 1Q16 margins of tobacco companies indicated mixed signals. Tobacco companies have been investing heavily in innovative products and other growth initiatives. This investment has impacted their margins.


Gross and operating margin comparison

Philip Morris’s (PM) gross margin fell by 0.7 points to 65.5% in 1Q16. Its reported operating income also fell by 13.9% to $2.5 billion in 1Q16. As a result, its operating margin fell by 2.8% to 41.9%. The fall was primarily due to the negative impact of $0.4 billion in foreign currency and an unfavorable volume mix of $0.2 million.

Altria Group’s (MO) 1Q16 gross margin rose to 58.6% compared to 57.9% in 1Q15. Despite a rise in its operating income, MO’s operating margin fell by two basis points to 43.6% in 1Q16.

Similarly, Vector Group’s (VGR) gross margin rose by 10.5% to 49.8% in 1Q16. It operating income rose by 26.5% to $0.06 billion in 1Q16, driven by Liggett’s year-over-year growth despite the competitive cigarette marketplace. However, its operating margin fell to 6.5% in 1Q16 compared to 7.8% in 1Q15.

Reynolds American’s (RAI) gross margin rose to 60.1% in 1Q16 compared to 58.7% in 1Q15. Its reported operating income rose by 786.3% to ~$6.1 billion. This included transaction-related and financing costs for its Lorillard acquisition and its related divestitures to Imperial Tobacco Group (ITYBY) as well as other litigation and exit costs.

Higher pricing variance

Tobacco companies aim to protect their margins through higher pricing, which may lead to lower shipment volumes. For example, Philip Morris expects a pricing variance of ~6% in 2016, which could help the company to achieve a full year of pricing broadly in line with its historical annual average.

MO and RAI together make up ~8.0% of the iShares US Consumer Goods ETF (IYK).1

Updated as of July 5, 2016

Tobacco Companies’ Stock Prices Hold Up despite Brexit

Tobacco stocks trade at their two-year peak

As of July 6, 2016, the stock prices of all tobacco companies have risen compared to January 2, 2015.

Despite global economic conditions and the United Kingdom’s vote to exit the European Union, British American Tobacco’s (BTI) stock price has risen by 20.4% since January 2015. The stock was trading at its two-year peak of $130.99 on July 5, 2016.


Philip Morris International’s (PM) stock has seen volatility since January 2015. However, the stock’s price has risen by 26.3% since last year and is trading at its two-year peak of $102.36. PM’s stock price fell by 1.3% to $99.28 after it released its 1Q16 earnings.

Consistent upward moving stocks

Reynolds American (RAI) has consistently seen upward movement, with an exceptional rise of 68.0% to $53.61 compared to January 2, 2015. However, RAI’s stock price fell by 0.2% to $48.31 after it released its 1Q16 earnings.

RAI’s stock gained momentum due to its recent collaboration with British American Tobacco (BTI) and its asset sale of Natural American Spirit to Japan Tobacco (JAPAF) (JAPAY) for $5 billion. To learn more about the deal, you can read Japan Tobacco Buys Natural American Spirit’s International Assets.

In comparison, Altria’s (MO) stock price rose by 1.0% to $62.19 after it released its 1Q16 earnings. It’s risen by 42.4% to $69.72 compared to January 2015. The stock has consistently seen upward movement. Also, Anheuser-Busch’s (BUS) acquisition of SABMiller (SBMRY) has impacted MO’s stock price, as MO owns ~27% of SABMiller.

Future outlook

Japan Tobacco’s (JAPAF) (JAPAY) and Vector Group’s (VGR) stock prices have also risen by ~51% and 10.0%, respectively, compared to January 2015. The benchmark S&P 500 Index (SPY) (IVV) (VOO) has risen by 2.0%.

Following Brexit, trade barriers will hurt exporters and companies with supply chains that rely on imports, such as the food and beverage sector. According to Moody’s, the average tariff for imports into the European Union is about 21% for beverages and tobacco. Declining cigarette volumes could also adversely impact stock prices.

Exploring Tobacco Companies’ Valuation Drivers

Relative valuation

Tobacco companies are trading at higher valuations compared to the S&P 500 Index (SPY) (IVV) (VOO) and the Dow Jones Industrial Average (DIA). Philip Morris International (PM) and Reynolds American (RAI) are trading at forward PE (price-to-earnings) multiples of 22.1x and 22.0x, respectively.

In comparison, the S&P 500 Index and the Dow Jones Industrial Average are trading at forward PE multiples of 17.8x and 16.7x, respectively. All valuations are as of July 6, 2016.


Despite adverse foreign currency impacts faced by Philip Morris in 1Q16, its valuation has risen exceptionally by 29.3% compared to the start of 2015. This rise has primarily been due to reduced gaps following price increases, leading adult smokers to upgrade to Marlboro and Fortune. Marlboro’s shipment volume increased by 1.4% in 1Q16, reflecting growth in Italy, Spain, Korea, and Mexico.

RAI’s stock price has spiked by 48.9% since June 12, 2015, when it completed the acquisition of Lorillard. RAI’s 1Q16 reported earnings rose by 591.7% to $2.5 billion and reported a 72.4% rise in adjusted operating income to $0.72 billion. As a result, its valuation has risen by 25.3% compared to the start of 2015.

Other companies

Altria Group’s (MO) valuation has also risen by ~25% to 22.4x compared to the start of 2015, majorly due to its SABMiller transaction.

British American Tobacco (BTI) and Japan Tobacco (JAPAY) (JAPAF) are also trading at higher forward PE multiples of 21.0x and 17.6x, respectively, compared to the S&P 500 Index.

Developing economies

As the industry struggles with falling smoking rates, higher sales taxes, and strict regulations in mature markets, developing economies have offered relatively better prospects.

Following Brexit, tobacco companies will also face import barriers which could push UK-based tobacco retailers to source more locally. Growing populations and rising disposable incomes in emerging markets act as top-down growth catalysts for this industry.

Exploring Tobacco Companies Growth Initiatives for 2Q16

2016 EPS guidance

Companies such as Philip Morris International (PM), British American Tobacco (BTI), and Japan Tobacco (JAPAF) (JAPAY) have presences outside the United States, making them vulnerable to foreign exchange translations.

In its 1Q16 earnings report, PM increased its 2016 reported earnings per share (or EPS) by $0.15 to a range of $4.40–$4.50. Also, the company expects its 2016 adjusted diluted EPS to be skewed toward 2H16 and 4Q16 in particular.


Reynolds American (RAI) expects its adjusted EPS to be in the range of $2.25–$2.35 for the rest of 2016. This represents a rise of 13.6%–18.7% compared to last year’s adjusted EPS.

Altria Group (MO) expects 2016 adjusted diluted EPS to be in the range of $3.00–$3.05. This range represents a growth rate of 7%–9% compared to an adjusted diluted EPS base of $2.80 in 2015, excluding NPM (non-participating manufacturer) charges, SABMiller (SBMRY) special items, asset impairment, exit and implementation costs, tobacco claims, and health litigation charges.

Innovation and distribution initiatives
Despite weak results, PM’s growth comes notwithstanding the significant incremental investments the company will make in 2016 to support the expansion of iQOS. iQOS is currently present in six cities of Switzerland, representing approximately one-third of total cigarette industry volume.

Altria also continues to expand Nu Mark’s distribution of MarkTen XL, for which results have been robust in leading markets. Additionally, SABMiller’s (SBMRY) merger with Anheuser-Busch InBev (BUD) will benefit Altria in its growth trajectory, as Altria has an economic interest in SABMiller.

Apart from creating RAI’s Innovations Company, Reynolds continues to focus on retail (XRT) distribution. For example, Reynolds has increased retail contracts by 50,000, growing its contract coverage to ~90% of total cigarette industry volumes.

To learn more about Reynolds American’s business, you can read An Essential Guide to Leading Tobacco Giant Reynolds American: Investor Must-Knows.

For more industry updates and analysis please visit our Consumer Products page.

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