Smoking Profits, with Reduced Risks

According to data from the World Health Organization, the global smoking rate has been steadily declining since 1980, with the smoking rate for men falling by 25% and for women by 42%. Just 31% of men and 6% of women now smoke, consuming just less than a pack a day on average.

But while the prevalence rate may be falling, thanks to global population growth the absolute number of smokers is up . . . way up. Over the past three decades the total number of smokers has grown from 721 million to 967 million, while the total number of cigarettes consumed annually has risen from not quite 5 trillion to 6.25 trillion.

Essentially all of that increase is in the emerging markets. When U.S. Surgeon General Luther Terry released the first report outlining the dangers of smoking in 1964, 43% of American adults smoked. Today, only about 18% of us light up on a regular basis. But while the anti-tobacco crusaders have scored a win here in the U.S. – and in much of the rest of the developed world – there have been sharp increases in the number of smokers in countries such as China, Indonesia, Russia and many other emerging markets.   

Obviously, the death knell was sounded for the tobacco industry in the early 2000s was a bit premature, even if the industry did have to retool a bit.

Altria was clearly ahead of the curve on that point, spinning out Philip Morris International (NYSE: PM) in 2008. While Altria hung on to its U.S. business, Philip Morris was given the exclusive right to make and sell the tobacco giants’ iconic brands, such as Marlboro and Parliament, outside the country. Thanks to that, Philip Morris sells the world’s top 15 brands in about 160 countries, with number one market share in 59.

Given its dominance, the tobacco group has managed to turn in slow but steady growth. Over the past five years, revenue growth has averaged about 4% annually while earnings per share have grown 9.6% thanks to industry-beating margins. That growth has helped to fund the company’s $1 per share quarterly dividend, even as it has been working an $18 billion share-buyback plan since 2008.

But while cigarettes may be the company’s specialty, it recognizes that emerging market consumers will one day get wise to the health risks associated with smoking. The company has invested nearly $2 billion to develop what it calls “reduced risk products,” designed to provide the pleasurable aspects of lighting up with so many of the harmful byproducts.

The company is currently working with two basic designs: battery-powered “e-cigarettes” that heat and aerosolize a nicotine solution and another that heats, but doesn’t burn, actual tobacco. While e-cigarettes are becoming more ubiquitous, it’s that latter platform which is actually most promising. Heat-not-burn technology gives users more of the tobacco taste and nicotine levels which smokers have come to expect, creating an experience more like smoking an actual cigarette. It creates fewer harmful chemicals such as tar, since the tobacco isn’t actually burned, resulting in a somewhat safer, similarly satisfying smoking experience.

Philip Morris CEO Andre Calantzopoulos is pretty optimistic about the products. He spoke to Forbes about these products in 2013, telling the magazine, “These products can bring the biggest single benefit in a short period of time, in terms of public health.” Aside from the health benefits, there’s also the bottom line to consider. Management predicts that reduced risk products could generate between $720 million and $1.2 billion in annual profits once the products are rolled out at full steam.

Given the promise of these new products, Philip Morris should be able to continue growing its dividend. In 2009 the company paid out $4.3 billion in dividends and repurchased $5.6 billion of shares. While full-year 2014 won’t be released for another week, last year it paid out nearly $6 billion in dividends and about $5 billion in repurchases. If these products help maintain even its mid-single digit revenue growth, dividends will maintain their upward trajectory.

So while the tobacco industry may face more challenges in the future, not the least of which is the risk that emerging market governments may take a regulatory approach similar to the developed world’s, Philip Morris International is already adapting to future challenges.

Smoke ‘em if you’ve got ‘em.