Altria/PMI: the resilience of Big Tobacco
An industry with a lethally addictive product offers billions of dollars to cap the liabilities that threaten its biggest companies: news this week that Purdue Pharma had offered up to $12bn to resolve claims relating to its role in America’s opioid crisis had analysts, investors and lawyers flashing back to the landmark settlement Big Tobacco struck with US states a generation earlier.
Yet at the same time came news that two of the world’s largest tobacco companies are in talks about one of the largest mergers in history, which could dictate the future of a product which kills an estimated 8m of its 1.1bn global users each year, according to the World Health Organisation.
The $200bn deal under discussion would reunite Altria with Philip Morris International, the overseas operation it spun off in 2008, in part to shelter shareholders from the legal storm clouds that hung over the US tobacco industry even after its $206bn-plus settlement of 1998.
The fact that the two makers of Marlboro cigarettes remain so highly valued, and have proposed reuniting, speaks to a resilience that has surprised and dismayed public health advocates.
“Like anyone who worked on the litigation 20 years ago I find it heartbreaking that the industry has continued to thrive,” says Doug Blanke, executive director of the Public Health Law Center, who worked on Minnesota’s cases against tobacco companies in the 1990s.
But the deal also reflects the profound disruption tobacco companies are facing, as the decline in cigarette consumption accelerates and a format war rages between technologies vying to give smokers ostensibly less harmful means of delivering nicotine.
What has brought PMI and Altria together again, analysts say, is the prospect of using the financial muscle and market power their legacy business has given them to gain a decisive advantage in that battle — even if it means killing the product the “Marlboro man” made famous in the process.
Financially, Big Tobacco has been more stable than investors dared to hope in 2008, when the two companies split apart. PMI’s exposure to emerging markets has allowed its revenues to grow by 15 per cent since then, while Altria’s US revenues have increased by 1 per cent.
Even in the US, the market investors once wanted shelter from, cigarettes have never been more profitable, says Wells Fargo analyst Bonnie Herzog — the result of their ability to get addicted customers to pay more.
Although some funds refuse to touch the industry, the fact that PMI and Altria both convert 80 per cent or more of that profit into dividends has lured other investors who are desperate for yield: last year UK fund managers at Allianz swapped the oil stocks in their portfolio for tobacco companies.
These robust financial headlines mask more troubling trends for the industry, however. In 2000, the WHO estimates, almost 27 per cent of the world’s adult population smoked: that figure has dropped below 20 per cent, with notable falls in major markets including Brazil, Russia and the UK.
The US has seen one of the biggest declines, from 23.3 per cent in 2000 to just 14 per cent in 2017.
For a decade, this shrinking pool of smokers has left the industry dependent on price increases to keep revenues growing. But with the US Centers for Disease Control and Prevention estimating that each 10 per cent increase in the price of a pack of cigarettes reduces consumption by 3-5 per cent, analysts now believe the escalating cost of smoking is accelerating its decline.
In July Altria said it expected cigarette volumes to fall by 5-6 per cent this year, rather than the 3.5-5 per cent decline it foresaw six months earlier. As tobacco analyst Erik Bloomquist puts it: “This wonderful cash-generating business looks to be more in danger than it ever has been.”
In the past two years another force has added to the pressure on cigarette demand: the number of smokers switching to alternatives.
Cigarette manufacturers have experimented with what they call reduced risk products for decades: RJ Reynolds spent $350m to develop a heated tobacco device in the 1980s, only to withdraw it when consumers recoiled at the smell of what even its chief executive reputedly dubbed “a turd with a tip”. None were successful until 2003, when the electronic cigarette was developed by Chinese pharmacist Hon Lik, who sold the patent to Imperial Tobacco for $75m in 2013.
Despite the billions of dollars cigarette companies invested in new technologies, it took a start-up to popularise e-cigarettes. Founded in 2015, Juul Labs has seized more than 70 per cent of the US vaping market, a market that is growing fast: the US now has 14m adult vapers alongside its 39m adult smokers, Wells Fargo estimates.
The speed of these changes has forced cigarette makers to respond. Last year, Altria invested $13bn in Juul for a 35 per cent stake, pledging to use its sway with retailers to promote Juul’s products.
The tobacco group’s efforts to diversify have also seen it spend $1.8bn on a 45 per cent stake in Cronos, a Canadian cannabis company, and $372m for a majority stake in Burger Söhne, the Swiss manufacturer of On, an oral nicotine brand.
PMI has set out a more aggressive vision of a “smoke-free” future, investing more than $6bn in a heated tobacco device called Iqos, which it hopes will one day replace cigarettes. Impressed with the early response to Iqos, particularly in Japan, Altria struck a deal to license the product in the US, where it plans to start testing the market with a trial in Atlanta next month.
That agreement may now be overtaken by the merger plan. Analysts who support the deal say it would let PMI capture the full value of Iqos in the US, while giving Juul the same promotional push overseas that Altria has promised for the US market.
Recombining the two Marlboro makers would not only give them united control of the world’s biggest cigarette brand; they would also own the industry’s leading heated tobacco product and a stake in its largest e-cigarette company, potentially allowing them to win regardless of which technology consumers favour.
Yet those arguments have not convinced investors who saw the case for Altria and PMI being apart. Shares in both companies have fallen at the prospect of a deal that would give Altria’s shareholders no takeover premium and expose PMI’s investors to the US market, which many of them wished to avoid.
“There is a strong possibility the deal will fail,” Adam Spielman, an analyst at Citi, told clients: “By having two companies listed, investors can choose the balance of pros and cons they want. By merging the two, management would be forcing investors to take the weighted average.”
But while tobacco investors once worried most about America’s lawyers, their biggest concern now is its regulators. “While US litigation risk was sufficient to break these companies apart back in 2008, US regulatory risk is on the same plane, in our view,” Stifel analyst Christopher Growe said this week.
The US tobacco industry is facing both the biggest regulatory threat to cigarettes since the 1990s, and deep uncertainty about how regulators will treat the new products it is counting on for growth.
In the past year the US Food and Drug Administration has proposed banning menthol cigarettes, which account for about a third of US sales, and said it could place more graphic health warnings on cigarette packets.
After a National Youth Tobacco Survey last year shocked regulators with the finding that more than one in five high school students admitted to vaping — up 78 per cent on the previous year — the industry is also bracing for a clampdown on e-cigarettes.
The FDA has announced restrictions on many of the flavoured products that it suspects have tempted a generation of children. By May 2020, it intends to require lengthy applications before any vaping product can come to market.
Juul has taken several steps to convince regulators it is serious about keeping its products out of young hands, but the FDA’s demands could be “a tremendous issue” for the company, Mr Bloomquist says. “If I’m an investor, why do I want to buy into a business where the theoretical upside is coming from another business which has an existential threat to it?”
There have been few long-term studies on vaping, but there is escalating concern in the scientific community about its impact on health.
Last week, the CDC said it was investigating the first death linked to an “outbreak of severe lung disease” among e-cigarette users. On Friday it issued a health advisory after receiving reports of 215 possible cases in 25 states.
A separate report that the Federal Trade Commission was investigating Juul’s marketing practices contributed to the slide in Altria’s shares this week.
Mr Blanke hesitates to speculate about whether these new risks could come close to the legal liability cigarettes once faced.
But he sees the products on which PMI and Altria are staking their future becoming the next battleground for public health advocates.
“We can count millions of lives saved,” he says about the decades of campaigning against cigarettes, but on his more pessimistic days he wonders: “Will it be another 70 years to get rid of e-cigarettes and then another 70 years to get rid of heated tobacco?”