Regulators Take Aim at High-margin Tobacco Products  

Source from:  Financial Times (uk)  11/15/2013

The life of a smoker is not a happy one. Thanks to increased regulation, smokers are banished outdoors, reminded in large type that they are killing themselves and forced to pay through the nose for the privilege.

By contrast, the life of a tobacco company is rather good. The $756bn tobacco industry has boomed even as regulators across the globe have heavily increased duty and introduced a host of tactics aimed at curtailing consumption – ranging from public smoking bans to graphic warnings and plain packaging.

"The environment is getting tougher from a regulatory point of view," admits Gareth Cooper, head of regulation at British American Tobacco, the world's second-largest tobacco company by market share. "But the industry has more than survived. It's incredibly profitable and successful."

Increasingly, however, regulators are going after the high-margin, fast-growing premium products that have spurred profit growth among big tobacco companies and made the industry's already fat margins even larger.

This is a global trend. The European Parliament recently passed a directive that will ban flavourings in cigarettes from 2022. Chile and Brazil have already done so. In the US, a ban on menthol cigarettes – which are gaining market share – is mooted. Even Russia – where about 40 per cent of people smoke – introduced a public smoking ban this year.

Until recently, regulation for the tobacco industry was a case of "heads we win, tails you lose". Margins are highest in heavily regulated markets, with high levels of duty.

"That is because of the excise – it gives more price leverage," says Alison Cooper, chief executive of Imperial Tobacco, the world's fourth-largest tobacco company by market share.

Tobacco companies can put up prices at the same time as duty increases, meaning they can raise their margins without incurring the wrath of smokers. Imperial's operating margin in the UK has jumped from 49 per cent in 1996 to 68 per cent last year thanks to price rises and cost cutting.

This applies across the industry. BAT expects its margins to improve by between 50 and 100 basis points each year. The operating margin of Philip Morris International, which sells Marlboro outside the US, has risen from 42 per cent in 2006 to 47 per cent today.

The gains have been achieved thanks to cost cutting, price rises and premiumisation: adding flavours to cigarettes, selling them in new forms – such as "slim" cigarettes – or designing fancy packaging.

"Premium cigarettes are the main cash-generation engine of the industry," says Shane MacGuill, a tobacco analyst at Euromonitor, the research group.

Going after the industry's cash cow has led to industry claims that this bout of regulation is aimed at curtailing their profits, rather than curtailing smoking.

"They want to make it difficult for the industry, to increase its costs, regardless of whether that is the most effective public health measure," says BAT's Mr Cooper. BAT already employs 450 people in its regulatory affairs team.

Tobacco companies have fiercely fought the latest glut of regulation. After decades of aggressive litigation from the 1950s onwards, the industry changed strategy and adopted a more stoic legal position in the late 1990s, broadly avoiding litigation.

This lull has come to an end, says Mr MacGuill.

"The tobacco industry is flexing its muscles. The reason we're seeing this is because tobacco companies know that these measures are the ones that will hit consumption and their bottom line."

BAT was vociferous in its opposition to plain packaging legislation in Australia. In the UK, Japan Tobacco International led the fight against plain packaging – at times with too much zeal. The Advertising Standards Authority ruled that some of JTI's anti-plain packaging adverts were misleading.

In a world of plain packs, no flavourings and no advertising, the spectre of commodification looms. "The more tools of differentiation are limited, the more it leads to reduced price premium, which is the road to commodification," says Martin Deboo, analyst at Investec.

With no other levers to pull, tobacco companies could turn to price cuts to gain an edge. But if this happens, volumes could rise to compensate for loss of margin.

Plain packaging has not had an effect on BAT and Imperial's volumes in Australia since it was introduced last year. But this has not stopped both companies complaining loudly about its potential introduction elsewhere.

Some companies are feeling the squeeze more than others. Last month Japan Tobacco, the country's biggest cigarette maker, announced it would shutter production at nearly half its domestic factories within the next three years in response to tax increases, tighter regulations and growing health consciousness.

In the US, restrictions or a ban on menthols would be particularly damaging to Lorillard, whose Newport brand – the US's leading mint-flavoured cigarette – drove 88 per cent of total sales in 2012.

But for most companies in the sector, even in a stricter regulatory environment, cigarettes remain extremely profitable. BAT's Mr Cooper is clear that tobacco companies will not be going anywhere just yet. "We're not going to disappear off the face of the earth." Enditem