Four Companies Control 94.8% Market Share of the Domestic Cigarette Industry in the United States
On this blog, in my articles, and even in my books, I have often used the example of how capital allocation determines the wealth one ultimately has. Many times, I used the illustration of a married couple, both of whom smoked a pack a day for 20 years, and calculated how much wealth they had seen, quite literally, go up in smoke.
There are two sides to every equation and, I realized, if someone is going to spend their precious capital on a product like cigarettes, I may as well own the company that sells them. That way, I can basically take the compounding they would have received and keep it for myself. This led me to begin researching the global tobacco companies, which I hadn’t looked at since I was a teenager.
A Side Note on The Morality of Selling Cigarettes
Some in my family have wondered how I could support buying shares of a cigarette company given that one of my grandfathers died from decades of smoking, which basically made it impossible for him to breathe. (Interesting thing about my family: it seems that a lot of the older generation died from vices: smoking, drinking, overeating, or refusal to go to the doctor. In contrast, those who were more temperate in their indulgences, and more faithful in caring for themselves, often lived a very long time. That is to say, fortunately, genetic longevity seems to be present in the family tree if a person can behave with prudence and restraint. It’s actually astonishing how much abuse some of the family members heaped upon their bodies before they finally succumbed to the consequences of their decisions, often decades later than you would have thought possible.)
How is it, then, that I have no moral qualms about the businesses? Because I believe people make choices and it is our responsibility to own those choices. It isn’t The Cheesecake Factory’s fault that their 1,000 calorie banana cream cheesecake tempts me from two blocks away. When the tobacco lawsuits were starting in the mid-1990s and I was in junior high and high school, I remember thinking how ridiculous it was that someone smoked two packs of cigarettes a day and then wanted to sue because they died young! It shouldn’t take a brain surgeon to figure out that puffing smoke isn’t good for you. The report on cigarettes being detrimental to your health came out in the 1960s! If someone hadn’t quit in the three decades since, it is their own damn fault.
Besides, if we are going to start drawing moral lines in the sand, heart disease and diabetes kill far more people each year than almost any other cause. By that metric, I should be boycotting Coca-Cola, Pepsi, Kraft and Nestle. That is ridiculous. It wasn’t Philip Morris’ fault that my grandfather died of smoking. It was his fault, just like it is my fault if I miss a day at the gym. When did the United States stop becoming the land of opportunity and start becoming a nation of blame-everyone-else victims?
The Domestic Cigarette Industry Looks Like a Cartel – Four Companies Control Almost 95% of Market Share
In the United States, Altria and Reynolds American hold roughly 50% and 28% market share of the domestic cigarette industry, respectively. Add in Lorillard and its 12.6% market share and Imperial Tobacco, with its 4.2% stake. An investor who owned stock in those four businesses would be in the interesting position of knowing that his or her tobacco investments controlled a combined 94.8% market share. That means that for every 100 people you see smoking a cigarette in the United States, you’d have likely made a profit on 95 of them.
R.J. Reynolds, which trades as its own stock but is effectively a partial subsidiary of British American Tobacco, disputes these figures. The firm states in its stockholder reports that it believes 16% of the total U.S. industry shipments from from deep-discount cigarette brands made by small manufacturers that aren’t subject to the huge tobacco settlement in the late 1990’s, giving them an enormous cost advantage. Even if that is the case, the combined market share of those four cigarette companies in staggering. (Side note: The biggest customer for many of these cigarette manufacturers is McClane Company, a subsidiary of Berkshire Hathaway that provides wholesale goods to convenience stores, restaurants, and other outlets.)
These companies definitely have their work cut out for them. Smoking rates in the United States are declining every year, and have been since the early 1980s. This is partially offset by population growth; that is, even if a smaller percentage of people are smoking, more people in the world means more absolute smokers help offset that trend. Still, it is ultimately a doomed business. If a pharmaceutical company could develop a treatment to cure nicotine addiction, it could devastate the major tobacco manufacturers overnight.
Furthermore, in 2009, President Obama signed into law an act that gives the FDA the authority to regulate the cigarette and tobacco industries, which could drastically curtail their ability to sell products. If, as part of the health care reform, Congress makes the cigarette companies go to plain packaging, refuses to allow the post office to ship cigarettes, refuses to allow online retailers to sell cigarettes, and continues to raise excise taxes, it is possible these companies could be put out of business and the stockholders experience significant losses.
Cash Flow Is King
Why would I even be looking at the stocks given these entrenched challenges? Cash flow. The companies generate so much cash it is obscene. We’re talking about 30% to 40% of every dollar of revenue falling to profits before taxes in some product groups. The old-line tobacco companies were smart enough to buy up other, stable cash generating firms such as Nabisco, General Foods, and Kraft. It wasn’t that long ago that every time you bought an Oreo or Kraft cheese, you were sending profit to the cigarette makers. That is no longer the case due to spin-offs but there is still a stream of earnings coming into the coffers with which management should be able to do something intelligent. Particularly because the tobacco industry is mature and almost all of the earnings money can’t be reinvested in the business for future growth. It has to go to share repurchases, cash dividends and / or acquisitions.
Still, the recent authority granted to the FDA to regulate the cigarette industry could mean huge volume losses in the future. Success in this industry is anything but certain. These are not “no brainer” stocks, like buying Coca-Cola at 8x earnings would be.
The Global Cigarette Industry Is More Promising than the Domestic Market
My favorite out of all the tobacco companies isn’t selling cigarettes in America at all. It is cigarette maker Philip Morris International. It is huge. It dominates almost any market in which it competes. It trades at a fairly attractive valuation. It generates tons of cash. It returns almost all of that cash to owners in the form of dividends and share buy backs.
The company was born out of the transformation at the old Philip Morris, which broke itself into three pieces over the past few years – Altria, Philip Morris International and Kraft Foods. Altria is the domestic company that controls the USA cigarette market. Philip Morris International got the rest of the world. Kraft became a stand-alone food company. All three are publicly traded and now completely separate from the others with their own board of directors, management, offices, production facilities, stockholders, bank accounts and strategies.
Why do I like the company so much? Virtually all of its sales and earnings are generated in foreign currencies but it reports its figures in United States dollars. If profits are up, but the dollar is up more, it could look like earnings fell even though the economic purchasing power of the company expanded in, say, Great Britain or Germany. That gives management tons of opportunities to use currencies from around the world to its advantage. If the dollar crashes, the company could take its Euros, convert them into dollars and buy back shares gaining a huge cost advantage.
It’s almost a play on the trashing of the U.S. dollar as the Federal Reserve continues to print money, we continue to run massive budgetary deficits, and our trade policies result in an imbalance. The weaker the dollar, the more profitable Philip Morris International. Even if the dollar stays strong, which it very well might, the company still generates obscene levels of cash flow.
Even with all of that said, again, the risks are there. An argument can be made that a person shouldn’t have a huge percentage of his or her net worth in these stocks unless they feel as if they have a good understanding of the demand projection. Personally, I like them as nice dividend holdings a la the Tweedy Browne & Company school of widespread diversification; passive long-term holdings that augment the larger, overall compounding machine, providing streams of funds to acquire other productive assets over time.
(Just for fun, here are the three new companies that were created after the old Philip Morris broke itself into pieces these past few years.)
The first was Altria Group [ticker symbol MO], which retained the old Philip Morris North American tobacco business as well as the smokeless tobacco companies. It has a market capitalization of $51.85 billion, a p/e ratio of 14.97, and a cash dividend yield of 6.10%.
The second was Philip Morris International [ticker symbol PM], which took the global tobacco business of the original company. It has a market capitalization of $107.3 billion, a p/e ratio of 15.87, and a cash dividend yield of 4.50%.
The third was Kraft Foods [ticker symbol KFT], which included the consumer food business selling everything from Oreos, Maxwell House coffee, Oscar Mayer, Cadbury chocolates, Trident gum, and Kraft cheese. It has a market capitalization of $55.19 billion, a p/e ratio of 11.53, and a cash dividend yield of 3.60%.
Update: Let me be very clear about this post and provide some historical context. Several years ago, I placed this piece, along with thousands of other posts, in the private archives. The site had grown beyond the family and friends for whom it was originally intended into a thriving, niche community of like-minded people who were interested in a wide range of topics, including investing and mental models. I decided, after multiple requests, to release selected posts from those private archives if they had some sort of educational, academic, and/or entertainment value. This special project, which you can follow from this page, has been interesting as I revisited my thought processes about a given company or industry, sometimes decades later. For me to be comfortable doing that, I made some non-material updates to clean up the text, add clarity, and improve the image resolution and format layout so it fits with the new blog template. The post was released from the private archive 05/26/2019. It was originally published nearly nine years prior on 10/22/2010.
A lot has changed in the nearly nine years that have passed since I originally published this post. The tobacco industry has transformed itself through mergers and acquisitions. Kraft broke itself apart into Kraft, which later merged with H.J. Heinz and become Kraft Heinz, a major portion of which is owned by Berkshire Hathaway, while its snack division became Mondelez International. Lorillard was acquired by Reynolds. In turn, Reynolds was acquired by British American Tobacco. Along the way, different regulators required certain brands from certain companies to be sold as part of deals. It’s been a bit like musical chairs in some capacity. In addition, my situation has changed, as well. My husband, Aaron, and I relocated to Newport Beach, California in order to have children through gestational surrogacy. Within a window of a couple of years around that relocation, we also sold our operating businesses and launched a fiduciary global asset management firm called Kennon-Green & Co.®, through which we manage money for other wealthy individuals and families. That means we are now financial advisors (or, rather asset managers operating under a investment advisory model as we are the ones making the capital allocation decisions rather than outsourcing those to fund managers or third-parties), which was not the case at the time this was written. Accordingly, let me reiterate something that should be perfectly clear: this post was not intended to be, and should not be construed as, investment advice. It was a short observation about the fact that most of the tobacco consumption in this country enriched a small number of firms.
Accordingly, due those changes and for the sake of full disclosure, I’ll state outright that Aaron and I, and/or some of the clients of our asset management firm, may own, buy, sell, or otherwise engage in transactions involving securities issued by any tobacco company, or any company in any industry for that matter, at any time, including, but not limited to, those mentioned in this post . For example, as of this morning, our asset management firm oversees portfolios containing millions of dollars in aggregate market value of tobacco-related securities for a wide range of private clients. We may wake up tomorrow and buy, sell, or trade any of these based upon our best professional opinion and client-specific factors. If we do, I have no obligation, and do not plan on, updating this post or informing my personal blog readers of such changes. This blog post was a historical artifact of a time in our life when my husband and I were private investors who founded and owned operating businesses, and I ran the Investing for Beginners at About.com as a side project, constantly sharing information about topics ranging from accounting to finance, economics to business history. Nothing in this post is meant to be a recommendation of any specific investment. None of my writing on my personal blog is meant to be investment advice. You should talk to your own qualified, professional advisors about what is right for your unique circumstances, goals, objectives, and risk tolerance.