Reading the Tobacco Leaves: How Long Will Smokers Keep It Up?
Date: Jun 11, 1999
By Daniel Kruger
Bond Buyer NewsEdge Corporation : Cigarettes are addictive.
That fact alone will ensure continued existence of the tobacco
industry for many years to come, securities analysts say.
But when it comes to analyzing what market conditions will
move cigarette consumption up and down during the next 25
years, affecting the level of payments tobacco companies
make to the states as part of their nationwide legal settlement,
the picture becomes unclear.
Between the first issuance of tobacco-backed debt, which may
happen later this year, and principal payments on final maturities
of the settlement securitizations, analysts say the industry could
undergo significant changes. They foresee many developments
that may complicate how Americans use and view tobacco,
including how changes in social mores and the emergence of
black markets, business decisions and market conditions,
developments in health and medicine, governmental agendas,
and plain old human nature will also influence the industry.
While questions remain, there are a number of reasons that
favor continued strong levels of tobacco use. In addition to
cigarettes being addictive, there are few alternatives to them.
Also, the companies that sell them operate in a brand-
conscious market, where already-high barriers to entry are
made harder by an agreement with the states that forecloses
many traditional venues for marketing the product.
The cost of the habit to smokers is another factor influencing
long-term survival of the industry.
As this year's decline in consumption indicates, "the demand of
tobacco is fairly elastic," said Michael J. Schroeder, who follows
the industry at Wasmer, Schroeder & Co., meaning that the
price of the product does have an influence on demand.
To maintain their financial strength, cigarette companies have
to "minimize negative impact of the necessary price increases,
to the extent more are necessary," said Roy D. Burry, a tobacco
analyst with Brown Brothers Harriman.
The companies have so far been successful in shifting the
settlement's cost to consumers, according to Burry. "We had the
big list price increases, but they were phased in over time," he
said. He added that Philip Morris Inc., the largest U.S. tobacco
company, is still discounting prices on brands and will probably
ease out of that strategy by the end of the year.
But the added expense of the settlement has already slowed
cigarette consumption by consumers, analysts say. With sharp
price hikes of about 65 cents per pack this year, consumption
is expected to fall between 6% and 10%, and analysts project
in subsequent years that decline will probably slow annually to
1% to 3%.
A Unique Product
When prices are higher, there is a very disproportionately
small decline in use, Schroeder said. "And you see that
largely because there's no substitute. Tobacco is a very
unique" product, he said.
Burry sees strength for the industry in a lack of new competition.
While the master settlement agreement between the
participating tobacco companies and 46 states forbids many
types of advertising and marketing, the industry was already
protected from new competitors, he said.
"You haven't got the brand names, the production capacity, and
all that stuff," Burry said. "The barriers to entry are formidable."
While the tobacco industry can clearly define market factors
that work in their favor, assessing factors that work against
them is trickier.
For example, there is no consensus regarding how consumers
will react to programs aimed at decreasing smoking through
price hikes in the form of the settlement or from taxes.
Emanuel Goldman, Merrill Lynch & Co.'s global tobacco analyst,
said demand for cigarettes will remain essentially the same
following settlement-related price hikes, but consumers will seek
ways to minimize how much they pay to smoke.
Some smokers may smoke less, or look to black or gray markets
to keep their costs of smoking as low as possible, Goldman said.
With large price increases due to the state settlements, and
states like California adding to the cost of smoking by raising
tobacco taxes, "what you have is people making their
adjustments" to consumption, according to Goldman.
He points to the increased number of cigarettes sold through
sharply discounted cigarette-only stores, up from 6% of sales
five years ago to approximately 18% today. He also points out
the British experience as they have jacked up the cost of cigarettes.
"Two things have happened as they've raised prices into the
sky," Goldman said. "One is a real black market, because what
it costs in Belgium is a fraction of the price in the U.K., same
brand." The other is the rise of the market for loose tobacco for
roll-your-own cigarettes. "If someone wants to smoke, they're
going to smoke," he said.
There are other issues over which analysts differ, such as the
possibility of more regulation.
Schroeder is concerned with the potential by the federal Food
and Drug Administration's attempt to regulate cigarettes as a
drug, particularly if smoking becomes an issue in the 2000
national election cycle and the tobacco companies become
political punching bags.
"If we see that happening, the purchase points and distribution
methods will likely have to be altered," he said. "You'll see heavy
restrictions on the use of vending machines, you'll see placement
of the product in supermarkets and drug stores and other venues
be more restrictive, and labeling will change, and advertising,
and so on and so forth."
But Goldman disagrees. "Don't hold your breath on FDA
regulation," he said, adding the U.S. Supreme Court is unlikely
to go along with the idea.
Health-related concerns of individual smokers, more than price
or any other factor, is responsible for making people smoke less,
according to Goldman. "The lion's share of people who have
given up smoking have not given it up because of price. I think it's
the health aspects," he said.
Many analysts also point to the risk of litigation by individual
smokers and their families, particularly after juries in California
and Oregon awarded the families of smokers judgments of larger
than $50 million each.
The risk from litigation is hard to quantify, however, in part
because of the tobacco industry's strong record of winning cases
brought by individuals and of successfully appealing the few they
have lost. And currently, both judgments have been reduced by
judges and are on appeal.
But the lawsuits may have an unintended negative consequence
that has hurt tobacco companies over the years.
One of the largest reasons for negative stories about the tobacco
industry has come from "internal documents that have found their
way into the court system and in front of juries and the media,"
He suggested the industry may be happy with the settlement
because it will end state lawsuits and the subsequent courtroom
revelations. "I think, internally, the industry was not really very
excited about having the whole world read these internal
documents," he said. "And who knows how many more are out
there that were amassed during years of research and
management changes and so on."
As time passes, analysts are unsure how the agreement
restrictions on advertising and marketing will affect the behavior
of teenagers, a demographic group the government most
heavily targeted in its campaign to reduce smoking. The
inability to advertise to this group could hurt financially because
teen smokers are likely to continue the habit when they become
The cigarette companies could face problems in establishing
themselves with another generation of potential smokers as
they come of age, Schroeder said.
Pointing out that social trends are very difficult things to predict,
Schroeder said that with more smoking "restrictions in
restaurants and other public places like airports, it will be
frowned upon and (become) a socially unacceptable practice."
To the extent anti-smoking attitudes rub off on kids, he said,
"that's a hurdle they're going to have to overcome somehow."
But Goldman disagrees with the idea that ads and marketing
have much to do with teenagers or young adults taking up smoking.
Having friends or parents who smoke is a stronger pull for kids
and teens than any advertisement, Goldman said.
"It's not because of a Joe Camel," he said, referring to a cartoon
character used to sell Camel cigarettes, but now banished from
billboards. "It's the peer thing."
Money spent on anti-tobacco ads will also reach a similarly small
audience, Goldman said.
"Just throwing money against the wall isn't going to help," he said.
"If you had targeted programs, maybe it might help, but I happen
to believe that most of the kids know all about smoking anyway."
Uncle Sam's Role
While the potential effects of governmental attempts to curb
smoking among American youth have yet to be seen, analysts
are agreed that the behavior of governments - national, state,
and local - will have a large impact on future cigarette consumption.
With the settlement payments falling or rising based on tobacco
consumption levels, Schroeder sees "a conflict of interest" for
state and local governments that with one hand are establishing
programs to halt teenaged smoking and on the other are now
planning on receiving those settlement payments over time or
issuing bonds against that money.
Schroeder said that though states may take the position that
"when you're settling with somebody, you've got to come up
with some kind of formula. So we had to separate those issues
from this particular business decision that we had to make -
what's best for the people of our state. Well, what's best for
which people in the state? The kids you don't want to smoke?"
If kids stop smoking entirely, "eventually the tobacco companies
will be out of business, and there goes your 25 years of big
windfall money, and how are you going to pay off the tobacco
bonds you're securitizing?" he asked.
"They're all in business together," Schroeder said, "like it or not."