Philip Morris and Altria: High Noon in Marlboro Country

Ever since the separation of Philip Morris International (PMI) from its former parent company Altria in 2008, the scenic Marlboro Country promoted in the famous ad campaigns has in fact been two countries. On the one hand there is the United States, birthplace of the modern reincarnation of the Marlboro brand, and on the other hand there is the rest of the world. PMI owns the Marlboro brand, as well as several others, in all non-US markets, while Altria markets the Marlboro brand in the United States through its ownership of Philip Morris USA (PMUSA). 

The separation of PMI from Altria was designed to untangle the international business from the tobacco litigation liabilities faced by PM USA, which weighed down the earnings multiple the market applied to Altria’s shares. Unmoored from Altria’s legal problems, the thinking went, PMI would be free to chase growth in emerging markets, unencumbered by the endless meetings focused on US legal strategy. After engineering and executing the PMI spin-off, former-CEO and chairman Louis Camilleri and then-PMI President Andre Calantzopoulos both left Altria to head Philip Morris International, then as Chairman/CEO and COO respectively, leaving Altria and its legal headaches behind. 

The plan didn’t work out nearly as well as intended. Tobacco regulation spread much faster across the rest of the world than was anticipated at the time. In some cases, developing markets have become far more restrictive in their tobacco regulations than the United States. Steep and sudden excise tax raises have also surfaced with increasing regularity, disrupting consumer behavior by impairing affordability and giving rise to large illicit tobacco markets. 

only A Fistful of Dollars

The most fundamental flaw in the separation of Altria and PMI, however, has been the lack of significant dollar earnings at Philip Morris International. For a company with its shares priced in US dollars, paying dividends in dollars and carrying part of its debt in dollars, the lack of a dollar earnings base should have been a serious concern before the separation. But with significant revenue streams in dozens of other currencies, PMI may have felt adequately diversified to withstand currency fluctuations. And this notion may well have been true if the company reported in any other currency than the US dollar. 

Unfortunately, the US dollar is not just any other currency; it is the world’s de facto reserve currency. It is both used and held widely by commercial and government parties outside the United States. This reserve status means that other currencies have often shown significant correlation in their movements versus the dollar, oftentimes as a result of (changes in) US central bank policy. The correlated movements of dollar exchange-rates quickly exposed the lack of a US earnings base as a major underlying weakness of PMI. As visualized in the graph below by the yellow bars, foreign exchange movements served as a drag on PMI’s revenues every year between 2012 and 2020. In 2015 for example, PMI suffered a ~$4.7 billion hit to its topline from adverse foreign exchange movements, approximately -16% of its prior year revenues net of excise taxes. After a positive foreign exchange contribution in 2021, the issue resurfaced in 2022 when the Federal Reserve began to more seriously tighten its monetary policy, leading to a resurgent US dollar. 

Philip Morris International: contributing factors in net revenue changes since the separation from Altria (left axis, in mln’s). The percentage change in overall net revenue per annum is visualized by the orange line (right axis). Please note that the contributing factors do not add up to a net cumulative revenue change as negative factors and positive factors are always shown below and above the $0 line respectively. All data from PMI financial filings. Graphics by the author.

The foreign exchange headwinds have been exacerbated by declining cigarette volumes, which were a negative contributor for 7 of the 10 years since 2012. Together, those two headwinds more than negated that traditionally reliable staple of tobacco company resilience: pricing power. As evidenced by the blue bars, PMI managed to raise prices on its products every year during its existence as an independent public company, oftentimes substantially so, but because of the negative forex effect higher local prices still translated into flat, or lower, dollar sales and earnings. In dollar terms, cumulative upward pricing totaled roughly $15 billion over the 2012-2021 period, while volume/mix was negative by approximately $3 billion. Adverse foreign exchange movements meanwhile shaved a cumulative $11.6 billion off net revenues over this period, while other other factors (acquisitions/disposals/etc) were negative by $1 billion. The net result of these contributing factors has been a flat topline for PMI between 2012-2021, which serves as the major culprit in PMIs languishing share price.

I have made the argument before that the Altria-PMI separation was a significant strategic error, and have advocated a merger between Philip Morris International and Altria. PMI actually proposed an all-share merger transaction in 2019, with the support of Altria’s board, but the proposal was quickly withdrawn for lack of shareholder enthusiasm. Since then PMI has lost its appetite for a combination with Altria, at least according to its current CEO Jacek Olczak. Tobacco litigation risk in the United States apparently still sits in the back of PMI shareholders’ heads. 

Once Upon a time… in america

Besides the lack of dollar-based revenues for PMI, there is another problem with the current situation. Lacking direct access to the US market makes the commercialization of PMI’s next-generation products substantially more complicated. This has become a more pressing issue in recent years because increasingly strict tobacco regulations globally have impaired the industry’s freedom to operate. Simply put, governments around the world are pulling the noose around the tobacco industry’s business model ever tighter. The uncertainty around the long-term viability of the industry’s current business model has put a substantial dent in the earnings multiples of tobacco company shares, which consistently trade at substantial discounts to consumer staples peers. This has made the transition to so-called reduced-risk products, such as heated tobacco products (HTP), far more urgent.

PMI and Altria have tried to work around this problem through a US partnership for PMI’s heated tobacco product IQOS, whereby Altria distributes and markets the product in the US while PMI continues to own the intellectual property and manages sourcing. However, the IQOS brand only achieved a tiny US foothold under this partnership, and its commercialization in the United States is currently on hold because of a ruling by the ITC. The ruling banned IQOS products from being imported into the United States because of a supposed infringement on  patents owned by Reynolds American, a subsidiary of British American Tobacco. 

The current situation is highly undesirable for PMI for a number of reasons. First, the US market is the world’s largest tobacco profit pool outside of China, which means PMI simply cannot afford to ignore the US potential for this product. Second, given the amount of R&D expenditures involved, heated tobacco products are a game of scale. Get to scale first and the virtuous cycle starts doing its work. Having the biggest revenue base means you can afford to have the biggest R&D budget, which significantly increases your chances of having the best product pipeline, which ultimately feeds back into your user acquisition, which feeds into your revenues etc. A significant US presence, through the sheer size of the American market, can significantly enhance IQOS’ global economies of scale.

Third, while PMI has a significant market leadership position in most heated tobacco markets, the US market is still up for grabs. Currently, PMI owns the only heated tobacco product with FDA-granted marketing authorisation. In other words, they could have the market entirely to themselves! But this window of opportunity will not last forever, as BAT filed a PMTA application with the FDA for its HTP Glo Hyper during 2021. Since BAT completely owns its US subsidiary Reynolds American, the company could move quickly to move its product to market once its PMTA application is approved. PMI is therefore operating under conditions of limited time if it wants to establish an early market lead for IQOS. This is important because an early market lead will likely prove to be a very valuable position as word-of-mouth endorsements serve as an important avenue for customer acquisition, especially since most advertising options are legally off limits. 

Fourth, the United States functions as a significant exporter of Western culture around the world; IQOS could derive substantial marketing benefits in other countries from being a relevant factor in America. Think of (social) media coverage, celebrity usage, or exposure to the millions of people visiting America from abroad. Since most markets now have restrictions on tobacco marketing in place, making the introduction of new tobacco brands and products quite complicated, this kind of exposure could be very valuable. 

A Fistful of Dynamite

Before the current halt of IQOS sales in the US, the product had only gained single digit market shares in a very limited number of metropolitan markets, primarily in eastern and southern US states. According to Altria the achievements made with IQOS in these markets met the performance targets agreed for IQOS under the joint marketing agreement. PMI however believes that Altria did not meet all of the performance targets, as surfaced in the fourth quarter earnings call (courtesy of Seeking Alpha).

Philip Morris CEO Jacek Olczak:

“I believe that that pre-ITC ruling IQOS performance in U.S. and you know how we perform with IQOS across all essential geographies. I mean it’s really well below what I would expect at this stage or characterize the potential of IQOS. And if I take into this, the fact that this is (an) inhalable FDA authorized product, you don’t really have a competition and the size of the market, et cetera, I think it’s fair to say that the expectations were much beyond where we are today.”

This rather unusual, public display of disagreement exposes an incentives problem underneath the US marketing partnership for IQOS. Whereas PMI has a clear incentive to maximize the addressable market for IQOS, and thus to establish a credible US presence for the product, Altria is looking at a very different strategic set-up. The latter is faced with a number of conflicting interests with regards to how it handles the IQOS partnership. First of all, the marketing of IQOS in the US creates a significant conflict with Altria’s existing cigarette business. After all, a majority of heated tobacco consumers around the world are converted cigarette smokers. Why would Altria want to convert smokers from its enormously lucrative Marlboro cigarettes to IQOS when the company has to share the margin with PMI?

At the same time, Altria has no incentive to decline the opportunity to sell IQOS in the US. This would only leave the product in the hands of a competitor, be it a US-based PMI-subsidiary or some other third party. This ties into the second consideration; like all cigarette companies Altria has an incentive to show regulators, and to some extent investors, that it is taking action to ameliorate the health impact of its business. 

Third, developing a proprietary heated tobacco product would take Altria a lot of time and capital, of which at least the first is in short supply. Fourth, as Altria does not own IQOS in the US, and is dependent on its partnership with Philip Morris International, it has to at least consider the possibility that PMI at some point excludes it from the IQOS business. If Altria achieves significant success with IQOS, at the expense of its cigarette business, only to be excluded by PMI at some later point, that would obviously be a very bad outcome.

Weighing those four considerations, it seems logical to conclude that Altria has an incentive to achieve at least some success with IQOS in the US, but not altogether too much. A cynic might propose that Altria may be incentivized to achieve only the bare minimum of its performance targets under the partnership agreement, as it stalls for time to develop its own heated tobacco product. At the very least this line of thought indicates that, although they are in business together, Altria’s and PMI’s interests are not at all aligned when it comes to the commercialization of IQOS in the US.

For a Few Dollars More

I believe that PMI has reached the point where it no longer sees either a merger or a US partnership with Altria as credible ways of establishing a successful American presence for IQOS. In fact, it has already sought an alternative way of reaching the US market by launching a bid for Swedish Match, a company which is focused mostly on selling oral tobacco products in the US and Scandinavia. In my opinion the buyout proposal makes perfect strategic sense from the standpoint of Philip Morris, since it offers the potential to address three of PMI’s pressing problems at once. First of all, Swedish Match has invested a lot of effort in developing alternative nicotine products that align well with PMI’s stated objective of becoming a majority smokefree company by 2025. A buyout of Swedish Match would allow PMI to include all of Swedish Match’s oral tobacco products, and not just the new ones, in its smokefree sales, making it far more likely to achieve its objective. It would also establish PMI as the leader in modern oral nicotine products, a small but quickly-growing category in which it currently has no significant presence.

Second, Swedish Match’s substantial US presence would give PMI an existing and already profitable sales platform through which it can distribute its IQOS product. This would give PMI the opportunity to end the poorly-performing partnership with Altria, and to take the US commercialization of IQOS into its own hands. If PMI contracts an American manufacturer for the IQOS devices and establishes a US-based manufacturing facility for the tobacco sticks, it could also sidestep the aforementioned ITC ruling, which after all only bans imports. Proceeding through this track would allow PMI to move the product back to market relatively quickly. Direct control over US-based manufacturing and sales should make for much faster progress than through the partnership with Altria. Third, the American operation owned by Swedish Match would give PMI a modest but expanding dollar earnings base, which could grow quickly if it successfully plugs IQOS into Swedish Match’s existing US sales organization. This would have the potential to ameliorate the company’s current sensitivity to foreign exchange rate fluctuations.

Of course, the acquisition of Swedish Match has not been closed yet, and may still run into problems. At the very least, there is the possibility that PMI will have to raise its offer for Swedish Match as some shareholders and other financial parties have voiced their opposition to the current buyout proposal. Given that Swedish Match shares have now traded, albeit modestly, above the price offered by Philip Morris, there seem to be more than a few market participants who are betting on a higher offer by PMI. The argument employed by some of the objecting parties is that the price offered by PMI is simply too low, although in the case of others it looks more like an arbitrage play on the prospective buyer’s estimated willingness to close the deal. 

From a financial standpoint PMI’s offer does not look particularly underpriced, especially not when we consider historical buyout valuations in the tobacco sector, the ever-present risk of regulatory disruption, and the fact that the multiple applied to the subject’s earnings includes not just the high-growth nicotine pouch business but also its profits from the more mundane cigars, moist snuff and lights business lines. Surely, PMI will not be particularly keen on paying a high multiple for profits achieved in those relatively small, moderate-growth businesses. It may even be considered likely that PMI will want to rid itself of Swedish Match’s cigars business, which would raise the effective multiple paid much further, since this business would probably fetch a much lower multiple on its own. 

On the other hand of the argument; Swedish Match offers PMI at least three different avenues to create value from a buyout. First, the abovementioned option to use Swedish Match’s US sales organization as a distribution platform for IQOS. Second, by riding US market growth for nicotine pouches on the back of Swedish Match’s Zyn brand, the category creator. And third, but not last, by taking Swedish Match’s nicotine pouch products and plugging them into PMI’s international sales organization in those markets where market potential for these products may exist. First and foremost this would be a number of European markets, but in all likelihood this product can be introduced into many other markets over time. Taking all these things into consideration, my current estimate is that, given the amount of opposition to the deal at the current price, and the clear benefits PMI would gain from owning Swedish Match, the likelihood of a higher offer by PMI is significant.  

The Not-so good, The Bad, and the Ugly 

Of course, the current situation in the US with regards to IQOS is still a temporary halt in sales, and a partnership that by the original agreement will run through 2024 and is subject to extension. It is difficult to foretell what will happen to the partnership if and when the proposed acquisition by PMI of Swedish Match takes effect. Currently, PMI is planning for IQOS to return to the US market during the first half of 2023, presumably by using domestically manufactured products and through Altria’s sales organization. My guess is that PMI will plan to discontinue the partnership once it comes up for renewal in 2024, and to switch the commercialization effort to Swedish Match’s US platform. 

Altria seems to have very few heated tobacco products alternatives to the IQOS partnership. It does not have a market-tested HTP of its own, and developing one would likely take at least several years and billions of dollars in expenses. And as Imperial Brands has learned in Japan, successfully launching a heated tobacco product as a latecomer in a crowded market is a very difficult thing to accomplish. Buying a heated tobacco product is also an unlikely alternative; apart from some unproven products sourced from China, there are very few companies with a credible HTP product in the marketplace. Altria’s acquisition of intellectual property with regards to a heated tobacco product marketed by Poda Holdings does not serve to inspire confidence in Altria’s position in this field. The product in question had achieved only negligible sales, and similar pod-based HTP products marketed by BAT and JT achieved very limited market success in Japan and elsewhere. The reason for that limited success is that pod-based HTP’s do not produce a strong enough tobacco vapor to adequately mimic the smoking experience. There is no evidence to indicate that any product developed from the intellectual property acquired from Poda would make for a more attractive user experience.

The only market-tested HTP’s that somewhat approximate IQOS in user experience are owned by BAT, Japan Tobacco and KT&G, all three of which are established tobacco industry players. Of those three, BAT is Altria’s largest competitor in the US cigarette market, while KT&G already has an international distribution agreement with PMI for its heated tobacco product named lil. This leaves Japan Tobacco as the only remaining option for Altria, if it wants to establish a heated tobacco presence of its own. While Altria and Japan Tobacco show very limited geographic overlap, and a merger is therefore unlikely to face significant regulatory scrutiny, an Altria bid for JT still seems like an especially unlikely scenario. Not in the least because the Tobacco Business Act requires the Japanese government to maintain a substantial shareholding in Japan Tobacco. 

A more likely scenario is for Altria to acquire from JT the rights to manufacture and market the Ploom heating device and accompanying sticks in the United States. Another conceivable option is for Altria to expand its ownership stake in Juul from 35% it owns now to a controlling stake, and to then use Juul’s vaping IP as a bargaining chip in negotiations with Philip Morris International or other international players. This may be the most promising option for Altria to pursue given Juul’s currently weak negotiating position. Perhaps Juul’s other investors will even be glad to be offered an exit. The downside to this option is that Juul has a significantly impaired public image in the United States due to its controversial marketing practices. The regulatory interventions that followed from the ‘teen vaping epidemic’ included an FDA-issued ban on all vaping flavors other than tobacco and menthol, and a rather arduous application process to gain marketing approval from the FDA. 

Not only is there a significant chance of products being denied FDA approval, but the controversy and the regulations that followed from the teen vaping fallout have caused Juul to lose a lot of market share in the United States, not in the least to disposable products not currently subjected to the FDA’s flavor ban. Acquiring a majority stake in Juul means its problems become Altria’s problems. Given the size of the impairments Altria has already taken on its investment in Juul, further increasing its ownership stake in Juul may not prove at all popular with its shareholders. It is undeniable, however, that despite all the controversy Juul owns very valuable intellectual property with regards to its vaping products. Also undeniable is that both the heated tobacco and the vaping market show significant market potential around the world. The next few years will show which companies have positioned themselves most favorably to capture that potential.

Disclosure: author owned shares in both Philip Morris International and Swedish Match at the time of publication.

Philip Morris Adds A Piece To The Smokefree Puzzle

Last week Philip Morris International announced it has agreed to buy Fertin Pharma from current owners EQT (70%) and the Bagger-Sørensen family (30%). The transaction value is roughly $820 million, for a price/sales multiple of somewhat over 5x, and an EV/EBITDA valuation of approximately 15x (using fy2020 financial data). Fertin Pharma started as a candy business in Denmark in the early 20th century, and subsequently expanded its operations into chewing gum and nicotine gum (1996). Its regular chewing gum brands, including Stimorol and V6, were sold to Cadbury Schweppes in 2001 and are nowadays part of Mondelez International. Since the branded candy exit, the company has focused its operations on developing products for oral delivery of nicotine, most prominently with nicotine gum, but has also developed know-how for delivering nicotine through lozenges, liquefiable tablets and pouches. Additionally, these delivery systems can also be deployed to deliver other active ingredients to the human body, such as vitamins, cannabinoids and caffeine.

Given the attractive market developments in recent years in such product categories as energy drinks, alternative nicotine products and cannibanoids, Fertin’s product portfolio fits well with PM’s stated goals of growing smokefree sales to 50% of total revenues and non-nicotine sales to at least $1 billion by 2025. Currently, Fertin operates primarily as a contract manufacturer for third parties, and not as a an important owner of branded products. Philip Morris is therefore buying the company for its technological and manufacturing capabilities, in my opinion primarily with regards to nicotine pouches. Nicotine pouches are the largest category in the modern oral nicotine (or MON) space and have shown very significant growth in recent years, particularly in North America and the Nordic and German-speaking regions of Europe. The outlook for these types of products is generally regarded as excellent due to their affordable nature, availability of flavors, ease of use and the dramatically lower health risk associated with their usage (when compared to cigarettes).

Even though PM is a clear frontrunner in smokefree nicotine products, which comprises heated tobacco, vapor and modern oral, the company is trailing its competitors in the latter category. Swedish Match and British American Tobacco have taken a clear lead in modern oral, while Altria has acquired Burger Sohne from Switzerland for its on! brand of nicotine pouches. Imperial Brands and Japan Tobacco are small players in this category, and are mostly competing with products launched by their existing Swedish snus subsidiaries (Skruf and Nordic Snus). PM’s acquisition of Fertin is meant to close the gap with its competitors in modern oral products, with Fertin adding the expertise and manufacturing capabilities to develop oral nicotine products while PM will likely assume responsibility for branding and marketing strategy. I believe the development and market introduction of a branded nicotine pouch product will likely be PM’s first priority after the acquisition closes. Longer term, Philip Morris may also explore possibilities for developing products with other active ingredients, as well as nicotine products with other delivery mechanisms. The deal makes a lot of sense from a strategic standpoint, at an acceptable price point, and since it is still early days in the modern oral category, PM is now in a better position to become a serious contender in this field.

(Disclosure: the author owns shares of British American Tobacco)

Altria and BAT: Will The FDA Go Menthol?

Yesterday the Wall Street Journal reported that the Biden administration is considering regulations targeting nicotine levels in cigarettes as well as menthol flavorings. With regards to nicotine, an addictive chemical present in tobacco smoke, the measure being considered is to only allow non-addictive levels of the substance in cigarettes. The potential measure with regards to menthol would be to ban it as a characterizing flavor in cigarettes, and possibly in other forms of tobacco as well. According to the report, the decisions regarding both initiatives have not been made yet. 

However, given the uncertainty created by the possibility of regulatory intervention, the market showed an adverse reaction in tobacco stocks like Altria. Regular observers of the tobacco industry can hardly be surprised by this development. The FDA, then under the leadership of commissioner Scott Gottlieb already announced similar intentions several years ago. The regulatory overhang has probably contributed to a significant discount in tobacco stocks since then. Therefore, this news report did not really deliver much of a surprise, but it does raise some questions. Namely;

  1. how likely are scenarios that either one, or both of these measures will be implemented? 
  1. how quickly will these policies be implemented if they are adopted? 
  1.  What will be the economic impact on the tobacco companies of both measures? 

Likelihood of menthol and nicotine regulation

Perhaps it is to be expected that the new administration, with a significantly more progressive agenda than the previous one, would like to move decisively on tobacco control. Regarding the possible implementation of menthol and nicotine content regulation, it should be noted that these ideas constitute very different tobacco control measures. Menthol regulation on the one hand is a tested tobacco control measure that has already been adopted in the European Union and Canada, while nicotine content regulation seems to be a more radical and untested approach. 

The rationale for menthol regulation is that it serves as a gateway for cigarette smoking by making the habit more palatable for new users, thereby fueling addiction and, by extension, long-term health damage. Removing mentholated cigarettes from the marketplace would presumably limit the uptake of smoking among youth, and might make it easier to quit for existing users. The fact that ethnic minorities are overrepresented as consumers of menthol cigarettes is an issue that has become more prominent over time, and has served as something of a rallying cause for minority advocacy groups in recent years. 

Given that menthol is an additive in tobacco products instead of a naturally occuring substance, the practical implementation of a ban would be relatively straightforward. A significant advantage with regards to implementing a menthol ban is that lessons can be drawn from experiences in the EU and Canada, who have already implemented such rules. If evidence can be presented from other countries that a menthol ban leads to a lower smoking rate, this clearly helps in building a public health benefit claim.

Nicotine content regulation on the other hand is a largely untested control measure, as it has not been implemented on a significant scale in other markets. Additionally, nicotine occurs naturally in tobacco leaves and a content rule would be far more intrusive and would likely require far more extensive cooperation from manufacturers in order to be implemented successfully. 

The rationale behind the possible introduction of non-addictive nicotine levels in cigarettes is that addiction to nicotine is the main reason why smokers continue to engage in behavior that causes severe long-term health problems in the majority of users. Taking the amount of nicotine in a cigarette down to non-addictive levels might raise the rate of success of smokers trying to quit, and might lower the risk of addiction in new users, or so the FDA thinks. The issue with this argument is that it is difficult to corroborate with data, because it is not at all clear how a lower level of nicotine would affect smokers’ behavior. For instance, it might lead smokers to smoke more cigarettes or inhale deeper, or it might lead them to different tobacco products, potentially even illicit ones. It would be hard to argue a public health benefit arising from such a rule if it may lead to more risky behavior in users.

Time-frame for implementation

The amount of time it might take for menthol and/or nicotine content regulation to be introduced in the marketplace is highly uncertain, and would depend to a significant extent on the regulatory path chosen to implement the new rules. I expect that the tobacco industry will try to challenge both a menthol and a nicotine content rule in court, something they did not do with regards to the recent tobacco-21 law.

Another unknown variable is the fact that the US senate has historically formed quite a formidable obstacle in the way of more restrictive tobacco laws. I presume that this is part of the reason why new tobacco restrictions in the US usually arise at the local level first. In the case of tobacco-21 measures, the adoption of federal legislation followed, rather than led, the implementation of more advanced age restrictions in many local jurisdictions. It is not entirely inconceivable that menthol regulation will follow a similar path, whereby a rising number of local jurisdictions where menthol sales are banned will at some point force the issue at the federal level.

In my opinion, both a menthol ban and a nicotine content rule would take several years at a minimum before they can be implemented in the marketplace. First, if new tobacco regulations are introduced as legislation, it is not at all a given that this bill would pass the US senate, where democrats currently possess only a razor-thin majority. Second, there is a significant chance that in case new rules are introduced by the FDA as part of its authority granted under existing legislation, these rules would likely be challenged in court.

Economic impact 

Regarding the economic impact of a menthol ban and a nicotine content rule, I would argue that a nicotine content rule would likely be more damaging to the tobacco industry’s long-term economic prospects. Of course a menthol ban would cause disruption in the US market, but in my opinion this would largely be a transitory issue. The US is the largest market for menthol cigarettes by far, estimated to constitute as much as a third of all cigarettes sold annually, but the dynamics of a ban are nevertheless likely to play out along the lines of what we have seen in Canada and the EU.

As we have seen in these markets, once menthol products disappear from the marketplace the addicts remain and usually switch their consumption to non-menthol cigarettes or other nicotine products. Some users will probably use the ban to try and quit completely. But because users overwhelmingly switch to other nicotine products, the impact of a menthol ban on tobacco companies usually comes down to a manageable event. After all, these companies are usually the ones that sell the alternatives as well. The most significant impact will therefore be related to changes in market share between different manufacturers, as well as differences arising from disparate profit contributions per product.

A nicotine content rule would in my opinion be far more disruptive to the tobacco industry because it potentially takes away or minimizes the addictive characteristics of the tobacco product in question. A tobacco product devoid of nicotine would probably experience a lot of problems in maintaining its marketplace relevance, given that it would no longer deliver the dopaminergic effects of nicotine to the brain. The delivery of nicotine to neuro-receptors in the brain and the pleasure effect it induces is the main reason why people find smoking enjoyable. Taking away or impairing this mechanism would probably severely disrupt the tobacco market over a prolonged period of time, the effects of which would only be ameliorated to the extent that consumers are offered satisfactory alternatives.

Despite this observation, a low-nicotine rule is unlikely to be the Holy Grail of tobacco control as some might like to conclude. First of all, it would be far more difficult to introduce successfully than a menthol ban would be, not in the least because manufacturers would have to be forced to materially alter a product they have marketed legally for many decades. Additionally, a low nicotine product landscape would likely leave many users with a nicotine addiction with few options to satisfy their craving. This might form an ideal breeding ground for an illegal market to arise in force, which would be an absolutely undesirable outcome.

For this last reason alone, I do not believe a low nicotine rule would be an effective tobacco control measure. A menthol ban on the other hand, would likely only temporarily cause disruptions in the US market but might deliver real health benefits to the extent it contributes to a lower smoking rate in the US population. It constitutes a more targeted and more reasonable measure than a nicotine content rule, is backed up by substantially more empirical evidence from similar measures taken elsewhere, and is therefore a substantially more likely candidate for successful introduction in the US than a low nicotine rule would be.

Disclosure: the author owns shares of British American Tobacco

Imperial Brands: A Weak Pulze

It has been quite an eventful year for tobacco purveyor Imperial Brands. Not only did Imperial cut its dividend for the first time ever as a public company, but it also saw a nearly complete overhaul of its senior leadership. Long-time CEO Alison Cooper has made way for Stefan Bomhard, formerly of Inchcape, and new appointments of a chief financial officer and a chief consumer officer were also recently made. 

In addition, the company has finally managed to close the long-awaited sale of its premium cigar business to a consortium of buyers from Asia. The sale of the premium cigar business was part of former management’s commitment to raise approximately £2 billion from asset sales, the proceeds of which were intended to strengthen the balance sheet and to put additional investment behind next generation products such as vaping devices and heated tobacco products.

The fact that the company fell substantially short of its divestment target is but a minor example of its failure to deliver on promises under former CEO Alison Cooper. When pressure from disgruntled investors started building a couple of years ago, there was little room for more disappointments. 

When the company’s US vaping sales were caught up in the fall-out from the EVALI uproar and the FDA’s subsequent crackdown on vaping products, Alison Cooper did not have enough credit left to ride out the storm. One week or so after the company warned on profit in the fall of 2019, the CEO’s departure was announced.

A man with a plan

More than a year later the company’s new CEO has recently presented a new strategy, which he believes will set Imperial Brands on the right track again. In my opinion, the new management team offered a very clear analysis of the company’s current shortcomings, which they primarily relate to its lack of a data-driven marketing approach, insufficient focus on key markets, and the distractions caused by next-generation products. As indicated in the presentation below, too many times in the past business decisions have been made without sufficient data to back them up, leading to subpar performance and significant market share losses in many markets.

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Key items detailing the new team’s assessment of past lackluster performance

Management’s analysis of Imperial’s business failures was followed by a detailed plan for how they will seek to improve the company’s marketing operations, and how this will gradually improve the company’s performance. The plan they shared was quite detailed and, as far as I can tell, it should be within the new management team’s capabilities to execute on it. Yet for me, the thoughts that lingered were not related to the plan on how to get the combustible business back on track, but rather the question of how the company intends to move forward with regard to next-gen products. And how difficult it will be for them to close the gap with its competitors.

If the world of tobacco was anything like it had been for decades, the plan management presented might well have met a more welcoming reception from investors. Instead, Imperial’s share price has languished near multi-year lows as investors were left to contemplate whether the new strategy will put the company back on track. In my opinion, navigating Imperial out of its troubled state and onto a more rewarding course will be a tough process for two reasons: 

  1. its development and commercialization of next-gen products is lagging significantly behind all of its major competitors
  2. turning the focus back to cigarettes and fine cut tobacco may deliver better economic results in the medium term, but goes against society’s decreasing acceptance of cigarette products

Regarding the first issue; Imperial Brands is so far behind the competition in next generation products that a significant consolidation of its efforts in vaping products has been deemed necessary by its new management. The leadership team under Mr. Bomhard intends to focus on a smaller number of vaping markets going forward, while keeping its oral nicotine products focused on markets with a preexisting habit of oral nicotine consumption. 

CEO Stefan Bomhard has referred to the  company’s blu vaping products as having previously been expanded too quickly, into too many markets, and without proper insights on consumer needs. The implication of this observation seems to be that these products are failing to gain significant traction in the marketplace, racking up substantial losses for Imperial, while lacking a clear path to profitability.

Retrenchment in next-gen may be the most obvious option available to the company, but admitting this has also highlighted Imperial’s NGP weakness. And while its larger competitors are racing to launch more new products into more markets, Imperial is proposing to move largely in the opposite direction. This  can only mean that the new management team has recognized how weak the hand is they are playing in these new categories. And although the decision might seem rational, the question investors should ask themselves is why they would want to join this management in playing a weak hand?

Imperial’s weak Pulze

Imperial’s heated tobacco product seems to be in even worse shape than its vaping products, where the company at least has a widely-recognized product in the market. Mr. Bomhard has referred to the heated tobacco product as showing promise, and having received too little prioritization under previous management. It is important to note that Imperial’s Pulze tobacco heater and accompanying tobacco sticks have barely put a dent into the Japanese market, which is currently the most important market for this type of product.

Compare this with Philip Morris’s IQOS product, which already has a presence in some 65 markets, or British American Tobacco’s Glo, which is currently present in 17 or so markets. When we add Japan Tobacco’s hnb product Ploom and KT&G’s lil, both of which currently have fairly limited but still meaningful geographic footprints, the inevitable conclusion is that Imperial is at best contending for a fourth or fifth place in this growing segment. 

Contending for fourth place is usually not a great position in any consumer product category but, given the unusual economic returns of the tobacco business, being a moderately sized contender has historically been a more than decently profitable position. It is not at all clear that this would be true for heated tobacco products as well. 

The amount of R&D dollars that Philip Morris has already spent on developing and commercializing IQOS strongly suggests that only those companies with significant market positions will be able to afford the expenditures that are required to develop and scale a successful heated tobacco device and still make a good return on investment. Aiming for fifth place, which in my opinion is really all Imperial can hope to achieve in this segment, is therefore a business strategy with a highly uncertain payoff.

Feeling blu

Imperial will likely withdraw its blu vaping products from certain countries where there is either poor demand for vaping products or blu currently holds a weak position. Instead of spreading its operations far and thin, as it did under Mrs. Cooper, from now on Imperial will focus on those markets that are already well-developed or show a very promising outlook. Consolidating its efforts on just a few important battlegrounds, such as North America and Northern Europe, seems sensible as these markets currently account for the overwhelming majority of vaping sales (outside of China). Gaining a strong market position in these markets will be key to building scale and a profitable business.

However, it is not a foregone conclusion that Imperial can turn its chances around, even if it is competing in a smaller number of markets. Imperial’s vaping products business is in particularly urgent need of improving its position in the US, a market where blu has long been an established player. In recent years the brand has lost a lot of ground to competitors Juul and Vuse though. Imperial’s pods-based vaping product MyBlu is estimated to currently hold a #4 position, at a very substantial distance to the dominant players. Stefan Bomhard has blamed the poor development of blu’s position in the US in part on insufficient retail support, and disruptions caused by the transition from Lorillard’s sales force, its previous owner, to ITG’s sales network (ITG is Imperial’s US subsidiary). 

The problem is that, even if Imperial increases sales support for blu and manages to increase its retail distribution, blu will likely still operate at a substantial disadvantage. Market leader Juul enjoys the benefits of its size in the market, and also has ties to the market leader in US cigarettes, Altria. Number 2 Vuse is owned by Reynolds, BAT’s US subsidiary, which occupies a strong number 2 position in US cigarettes, and benefits from its tobacco sales force. ITG on the other hand, has a weak number 3 position in US cigarettes, which means blu is unlikely to ever match its competitors’ strengths in distribution.

Another point of weakness is the fact that vaping is more of a scale business than conventional tobacco is. Just like heated tobacco devices, the amount of R&D expenditures involved in the development and marketing of vaping products is quite significant. The dominant players will increasingly benefit from their ability to charge large R&D and marketing expenditures against a much larger number of devices and refills sold, and will therefore benefit from having lower marginal product costs. Those savings can be put to productive use in regulatory compliance for instance, to an extent smaller competitors like blu simply cannot match.

Tobacco in an ESG world

While innovation is a very important driver of economic value (and value destruction) in any economic activity, the tobacco industry does not solely have an economic reason for innovating and trying to move beyond combustible products. It also has an increasingly urgent social acceptability problem with regards to its traditional business. The serious health consequences of tobacco consumption mean that tobacco stocks are increasingly avoided by investors looking for a financial as well as a social return on their capital. 

The rise of purpose-driven investment has been quite profound in recent years, in part because of increasing concerns over environmental impact, and is usually referred to as ESG (environment, social, governance) investing. With regards to tobacco companies this trend can be witnessed clearly in the increasing numbers of signatories to such initiatives as Tobacco Free Portfolios, which is a pledge institutions can sign to divest all tobacco-related investments from financial portfolios.

The decline in social acceptance has gone hand in hand with increasing regulation, thereby casting doubts over the tobacco industry’s future. While the industry has, from an economic standpoint, generally been quite effective in navigating these challenges, the risk of regulation has in recent years had quite a detrimental impact on public tobacco company valuations. The combination of decreasing social acceptance and increasing regulatory risk make the effort to develop products that are less harmful not just a matter of thriving in a competitive market, but also of earning a ‘license to operate’ from society. 

It is quite evident in today’s market that companies with rapidly increasing sales of ‘reduced-risk’ products, such as Swedish Match and Philip Morris International, are valued at substantially higher multiples of earnings than companies that have been slower to move in this direction. Imperial Brands unfortunately fits in with the latter group; fixing its conventional tobacco business may make perfect sense, but if society becomes even less forgiving towards its main business, it may not lead to an much improved share price at all.

Disclosure: the author owns shares of British American Tobacco.