Philip Morris' Response to Critics Should Put Investors at Ease

Australian radio show host Mark Colvin has accused Philip Morris International and British American Tobacco of lying about the effectiveness of plain packaging laws. Australia's plain cigarette-packaging laws, introduced in December 2012, are at the center of the war on the tobacco industry. Anti-tobacco activists worldwide are monitoring the effectiveness of the laws, which require standardized fonts and drab colors on all cigarette packaging, with the intent of implementing them in their own countries if the rules effectively curb cigarette consumption. As a result, cigarette makers have a strong incentive to show that the laws are ineffective.

Philip Morris and British American Tobacco claim that cigarette sales have actually increased since plain packaging laws went into effect, but Colvin and his radio show guests dispute that notion, citing contradictory evidence from government records. Proving who is right and who is wrong could be the difference between an effective worldwide crackdown on cigarettes or continued dividend growth for tobacco companies.

All statistics are lies
The tobacco industry breathed a collective sigh of relief when industry data showed an additional 59 million cigarettes were sold in Australia during 2013, a 0.3% increase in consumption compared to 2012. Philip Morris' CEO told investors that plain packaging was having "no impact on [smoking] prevalence or incidence" a year after its introduction, although he admitted that it caused some consumers to trade down to discount brands. This was a major coup for the tobacco industry, which views packaging as a key differentiator in markets where other forms of advertising are banned.

However, guests on Colvin's radio show claim that data from Australia's Federal Treasury contradict Philip Morris' claims. According to Treasury data, 3.4% fewer cigarettes were sold in 2013 than in 2012. One of the show's guests, Anne Jones, claims that Philip Morris and British American Tobacco have outright lied about the effects of plain packaging. Jones said the industry's history of lying and the fact that data showing the increase has not been released for public scrutiny supported her claim that the companies were misinforming the public.

However, the discrepancy between industry data and Treasury data may be explained by differences in measurement. In response to media criticism, Philip Morris released a statement that explained how the law's introduction in the fourth quarter of 2012 caused the company to recall and replace significant amounts of inventory that did not comply with the new regulations. However, the company had to pay excise taxes on the new inventory before the Treasury had processed its claims for tax refunds on the replaced inventory. This may have caused the Treasury to double-count industry sales in the quarter, while industry statistics would have taken the inventory replacement into account.

If the Treasury also counted the refunds processed in 2013 against sales in that year, then its figures artificially inflate 2012 cigarette sales and artificially deflate 2013 sales. As a result, the Treasury figures are compatible with the tobacco industry's figures, but the tobacco industry's measure is more useful for gauging the impact of the law.

The real effects of policy
Even though generic packaging has not yet had a negative impact on cigarette volumes, it has had a negative effect on Philip Morris. Since Philip Morris' packaging in Australia now looks similar to all other brands' packaging, an increasing number of smokers now reach for the cheapest pack.

According to Nielsen, the Australian market share of legal cigarettes priced below $15 has grown 35% since 2011 -- the last full year before plain packaging was introduced. This hurts Philip Morris, since it derives most of its revenue from premium-priced cigarettes, while benefiting British American Tobacco, which derives most of its revenue from low- and mid-priced cigarettes. British American Tobacco already has a 43% share of the Australian market, a share that is set to expand if plain packaging laws remain in place.

Australia's plain packaging laws will only affect Philip Morris' and British American's shareholders if other countries join in adopting the rules. However, since the data indicate that plain packaging only serves to shift consumption from premium brands to value brands, the measure may not gain worldwide support. In fact, it may serve to increase consumption, since smokers who would have otherwise paid more for a premium pack now have leftover money to buy more value packs. As a result, anti-tobacco activists in other countries may cool to the idea of plain packaging -- benefiting Philip Morris shareholders.

Foolish takeaway
Interested parties on both sides of Australia's plain packaging debate are crafting statistics to prove their case. The battle is far from over, but it appears that the laws have not yet had their intended effect. Instead, generic packaging has caused smokers to buy cheaper cigarettes, potentially allowing them to smoke even more cigarettes. As a result, investors should not be concerned that generic packaging laws will sweep the globe, putting Philip Morris' premium brands at risk.

However, Philip Morris and British American investors should keep a close eye on the data to determine what the true long-term effects of these laws will be. The outcome could determine the ability of both companies to grow their dividends in future years.

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