For years now, the tobacco industry has battled a declining U.S. smoker base and a barrage of anti-smoking campaigns. Yet the major players in the industry continue to prosper.
Despite smoking prevalence in the U.S. declining to all-time lows since the 1940s, when Gallup began tracking smoking rates, Reynolds American (RAI), Lorillard (LO) and Altria (MO) -- the three American tobacco giants -- have stocks trading at their five-year highs.
But now, these companies might soar higher than ever on the back of a new trend -- one that gets around pesky smoking laws and quarantine-esque smoking lounges.
In the U.S. as well as abroad, electronic cigarettes are fast becoming a common sight. These relatively new products take liquid nicotine and vaporize it, allowing the smoker to inhale normally while avoiding the carcinogenic tobacco smoke and smell.
A Morgan Stanley (MS) research team recently concluded that e-cigarettes will replace 1.5 billion traditional cigarettes this year alone. An executive with Lorillard was quoted as saying the rapidly growing segment will account for 1 percent of the business by the end of the year -- a startling growth rate. Wells Fargo analyst Bonnie Herzog puts sales of the products at more than $10 billion by 2017.
Clearly, at least one tobacco company is bullish on the trend. Lorillard's CEO went as far as to smoke a Blu e-cig at the New York Stock Exchange.
With the three big guns releasing or updating their products to combat the start-ups who have gotten to market first, is "big tobacco" destined to become "big e-tobacco"?
Selling a Breath of Fresh Air
For tobacco marketers, e-cigarettes must seem like a breeze to sell compared to pushing real smokes.
For one thing, e-cigs can be advertised on television and radio, as opposed to normal tobacco products, which have been off the airwaves for 40 years. The products can be promoted with kiosks and sold at checkout counters.
Blu, one of the biggest early players in the space, has celebrity-endorsed commercials advocating users to "rise from the ashes." In 2012, Lorillard bought the company for $135 million, mirroring the actions of Reynolds American, which is relaunching its Vuse e-cig, and Altria, which is getting ready to introduce its MarkTen e-cig.
Right now regulators are behind the ball, enabling marketers to make whatever claims they want. Some makers -- though not the major tobacco companies -- are claiming electronic cigarettes are a formidable method of kicking the habit, appealing to smokers (as a way to satisfy nicotine cravings in nonsmoking environs) and trying-to-quit smokers.
On the business side, the big question is whether e-cigarettes will kill big tobacco's core product -- actual tobacco.
Don't Call an Ambulance Just Yet
Before you begin to worry about the future of tobacco, consider that the declining U.S. smoking rates, while certainly troubling, do not spell apocalypse for the industry. Even the tremendous anti-smoking momentum in places such as Australia, the U.K., and Canada is not enough to bring these businesses down.
The reason for cigarettes' staying power is simple: the third world.
In the developing areas of the world, smoking reigns supreme and is even gaining momentum.
Anti-smoking advocates are pushing for intervention in developing nations, with the World Health Organization, in particular, citing the potential for 1 billion tobacco-related deaths in the 21st century.
The only problem here, well, aside from the global epidemic concerns, is that American Big Tobacco does not have meaningful international exposure.
Altria, formerly the full owner of Philip Morris and the iconic Marlboro brand, spun off its international interests into a separate company -- Philip Morris International (PM). From 2010 to 2012 the company's sales have grown by nearly 13 percent, proving that a pure place on the cigarette business, without the diversified interests such as e-cigarettes (or even plan leasing, for Altria), is still a growing business in other corners of the world.
The Bottom Line
The tremendous growth of e-cigs will, without a doubt, take market share away from the old-school cigarette, and big tobacco will have to make some changes to address the new trend.
But this isn't a story akin to Blockbuster and Netflix (NFLX).
Reynolds America, Altria, and Lorillard aren't relics of a vanishing world. They will be a major part of the e-cigarette revolution, and they will find plenty of tobacco-huffers in the developing world -- if they can build out their international presence.
As investors, do not fear the technology disrupting the industry. The important factor is to keep an eye on the progress of regulation. Some states and cities have taken motions to ban e-cigs and outlaw them from sale to minors (yes, a minor can currently buy an e-cigarette in some areas), and the federal government is working fast to control this new Wild West of nicotine delivery.
In the meantime, though, expect those big tobacco companies to continue their profitable ways.
Motley Fool contributor Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix and Philip Morris International.
America's Most Profitable Products
Smoking Rates Are on the Decline, but Not So Big Tobacco
Garmin is a navigation device company, focusing on GPS technology. By far, the most profitable of the company's five divisions on a dollar basis (though other divisions have better margins) is the automotive/mobile group, which makes and sells Garmin's GPS units. This segment accounted for 55% of the company's sales in 2012 -- $221 million in operating profit on $1.5 billion in revenue.
Much of the segment's success was due to Garmin's nüvi product line, which accounted for 43% of the company's total revenue in 2012. Garmin is by far the largest participant in the GPS market, with over a 50% market share, according to Consumer Reports.
Folgers is owned by the J.M. Smucker Company, which reported sales of $5.5 billion in 2012. Of those sales, $2.3 billion came from coffee. The company's U.S. retail coffee unit, of which Folger's is the top-selling brand, reported an operating margin of 23.6%, which is down from 27.8% in 2011 and 28.5% in 2010. We estimate that Folgers has an operating margin of at least that. The brand is the market leader for instant coffee in the U.S., commanding an 11.8% market share as of 2012. However, this is down from 13.2% in 2011. J.M. Smucker cut the price of coffee by 6% in 2012, which will affect the bottom line for both its Folgers brand and Dunkin' Donuts-licensed coffee.
That high profitability is even more impressive given that it was earned in a highly competitive market niche, vying against brands like Maxwell House and Starbucks.
The Mead Johnson Nutrition Company primarily sells infant formula and nutritional products for children, and formula accounted for 59% of its total sales in 2012. The vast majority of that came from Enfamil, one of the best-selling infant formula brands in the U.S. The product comes in several varieties designed for babies with different types of feeding problems, intolerances and nutritional needs.
According to Crain's Chicago Business, Mead Johnson had the second largest market share in infant formula as of mid-2012: 15.1%. The company was also the leader in the rapidly growing Chinese formula market. The company's operating margin in fiscal 2012 was 22.3%. We estimate Enfamil has a margin of at least 24%, thanks to the higher retail prices it can command due to its strong brand, as well as lower production costs due to economies of scale.
Coca-Cola and Diet Coke were the two most popular sodas in the world as of 2011, Diet Coke having recently surpassed Pepsi to become the second-most popular soft drink in the U.S. Overall, trademark Coca-Cola products accounted for approximately 48% of all case sales of finished products sold by the company in fiscal 2012.
Given that Coke's finished products unit, which includes the Coca-Cola brand, accounted for 62% of total revenue for the company, Coca-Cola trademark drinks accounted for roughly 30% of the company's total revenue. Overall, the Coca-Cola Company reported 2012 sales of $48 billion and an operating profit of 22.4%. We estimate that the tremendous sales of the company's flagship brand push its operating margin to 25%. BrandZ reports that Coke is the world's sixth most valuable brand name, with an estimated value of $74.3 billion.
Monster Beverage Corporation had net sales of roughly $2.1 billion in fiscal 2012, with an operating income of $551 million. According to market research company Symphony IRI, in the 52 weeks ending February 24, Monster-branded energy drinks accounted for 37.2% of the market, just behind rival Red Bull. In that period, the company sold approximately 1.2 billion cans of its Monster-branded products, including almost 776 million cans of its original Monster beverage. Because Monster-branded drinks accounted for 92.3% of total company revenue, we have treated the company's 26.7% operating margin as a proxy for the energy beverage.
However, business isn't entirely a fairy tale at Monster. The company has recently faced criticism and legal troubles, including a wrongful death suit and a Food and Drug Administration report that linked several deaths to Monster Energy beverages.
Marlboro cigarettes are sold by Altria Group in the U.S., and elsewhere by Philip Morris International -- which Altria spun off roughly five years ago. Marlboro branded cigarettes have made both companies extremely profitable. Altria's sales of smokeable products totaled roughly $22.8 billion in its most recent full year. That figure accounted for 90% of total company revenues, and 85% of units sold were Marlboros. Altria's smokeable products unit has an operating profit of 28%. Because Marlboro is the company's strongest and best-selling brand, it is 24/7's estimate that costs to produce those cigarettes are lower than the company's discount cigarette lines. As a result, we estimate that Marlboro has an operating margin of at least 30%. BrandZ calculates that Marlboro is the world's seventh most valuable brand at $73.6 billion.
The iPhone is by far the most successful product Apple sells. Of the company's $156.5 billion in 2012 worldwide sales, $80.5 billion came from iPhones. Apple sold more than 125 million units last year, a 73% increase over 2011. In contrast, Apple sold 58.3 million iPads that year, generating just $32.4 billion in gross revenue. Each iPhone is far more profitable than each iPad, the company's second best-selling product. According to documents released as a result of the patent lawsuit between Apple and Samsung, Apple's gross margins on the iPhone were between 49% and 58% from April 2010 to April 2012, nearly double those of the iPad. This is partly because wireless carriers subsidize the iPhone heavily -- an average of $425 apiece, according to a recent Stifel Nicholaus analysis. Based on the available data, we calculate the iPhone's profit margin is 40% -- even higher than Apple's overall 35.3% margin.