Admittedly, cigarettes used to be a great business. As Warren Buffett (Trades, Portfolio) described it: "It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty." However, the traditional tobacco industry has mostly seen quite some challenges resulting from greater awareness of the risks associated with smoking, improving cessation therapies, as well as the secular decline in cigarette volume that was accelerated by the vaping alternative lately. Over the last couple of years, major tobacco companies, including Altria (MO, Financial), Philip Morris (PM, Financial), British American Tobacco (BTI, Financial) and Imperial Brands (LSE:IMB, Financial), considerably underperformed the market benchmark.
A smoke-free world may appear to be inevitable, but how should investors position themselves? To answer this question, we would like to explore two high-quality businesses that embrace this structural shift.
Philip Morris
Swiss-domiciled Philip Morris sells cigarette and tobacco products in over 180 countries, with a claimed market share of 15% globally (excluding China and the U.S.). The company owns (or co-owns) six of the top 15 international brands in the category, including Marlboro, Parliament and L&M. But none of these cigarette names points to a sustainable future for Philip Morris. Instead, the world's largest tobacco producer (by market cap) intends to leverage the resources provided by its combustible tobacco portfolio to invest in its "vision of a smoke-free future" and "the ultimate transformation" of its business.
Philip Morris employed a different approach from its former parent Altria, which bought a stake in Juul in 2018 but later took a hit mainly due to the growing number of legal cases relating to teen vaping in the U.S. The company piloted IQOS, a heat-not-burn tobacco platform, in Japan in 2014, and then has expanded the presence into over 50 markets worldwide, with millions of combustible smokers having switched over now. Financial data shows that the reduced-risk products represented almost 19% of the total sales at Philip Morris as of fiscal 2019, up from 13.8% in the previous year with year-over-year revenue growth of 36.4%. Underneath the top-line growth lays the powerful razor-and-blades business model of IQOS that delivers high-margin recurring revenue.
The return on assets at Philip Morris has been consistently maintained at above 15% over the past decade and has outperformed major peers in the industry.
Swedish Match
When it comes to American consumers, IQOS is not the first to obtain the Food and Drug Administration's approval to be marketed as a safer alternative. Check out the Snus smokeless tobacco products sold by Swedish Match (OSTO:SWMA, Financial) under the "General" brand, which was granted the first-ever modified risk order by the administration in the U.S. last October.
As of fiscal 2019, Snus and moist snuff accounted for a little more than 50% of the total revenue at Swedish Match, up from 47% in the previous year with a 22% sales growth of the segment. The Swedish company holds the market leadership in Sweden, Norway and South Africa and the number three position in North America, when it comes to the category of chewing tobacco. Besides, it also produces cigars and cigarillos (approximately 39% of total sales) as well as matches and lighters (8%).
According to management, Swedish Match aims to create shareholder value by "offering consumers enjoyable nicotine-containing products of superior quality in a responsible way." As with Philip Morris, the business also earned a return on assets in excess of 15% every year for the last decade.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Philip Morris.
Read more here:
- The Technology-Proof Consumer Businesses​
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