Altria, Philip Morris International Join Forces In Commercializing Cigarette Alternatives

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Altria ( MO ) and Philip Morris International ( PM ) recently entered into a strategic agreement involving cross-licensing of their lower risk products to tap the burgeoning market. While the former controls more than half of the U.S. cigarettes market, the latter, which was spun off from the former in 2008, leads the international market, excluding China. We believe that the cross-licensing agreement, which also includes cooperation in regulatory engagement for e-cigarettes and advanced tobacco products, improves long term growth prospects of both the companies as they face increasingly tough conditions in the traditional cigarettes market.

We currently have a $43 price estimate for Altria , which is valued at around 17.7x our 2013 Non-GAAP EPS estimate of $2.43, and is ~10% above its current market price.

See Our Complete Analysis For Altria

Declining Traditional Volumes

Both Altria and Philip Morris International have witnessed increased pressure on volumes in 2013 due to anti-tobacco measures and growing prevalence of e-cigarettes. During the first nine months of this year, while Altria's cigarette shipment volume declined by 3.6%, Philip Morris International shipped 5% fewer cigarettes compared to last year.

Philip Morris International's shipment volume this year has been negatively impacted by anti-tobacco regulatory measures in the key markets of Philippines and Russia. Apart from this, continued volume pressures in the EU, due to the growing prevalence of illegally traded cigarettes amid weak macroeconomic conditions, also weighed on the company's results. (See our complete analysis of Philip Morris International's Q3 2013 Earnings: Philip Morris Lights Up Earnings Growth On Pricing Gains Despite Lower Volumes)

On the other hand, Altria's cigarette volumes have fallen faster than the historical average rate of around 3% this year because of an accelerated decline in cigarette consumption in the U.S., driven largely by increasing use of smokeless tobacco products and electronic cigarettes. This is primarily due to the challenging regulatory environment, which is marked by highly restrictive marketing rules and ever-increasing indirect taxes.  Also a factor is growing health consciousness among U.S. consumers.

Emerging Alternatives

Through its diversified approach, Altria has been able to capture the consumer shift towards smokeless tobacco products, as it operates the popular Copenhagen and Skoal brands, which hold more than 50% retail market share in the segment. However, it has been late to enter the burgeoning e-cigarettes market in the U.S. The company began selling its MarkTen e-cigarettes in the test markets of Indiana and Arizona only in the second half of this year. The second largest U.S. tobacco company, Reynolds American, plans to launch its Vuse e-cigarettes nationally next year. Lorillard, on the other hand, owns the top selling e-cigarette brand in the country, blu.

Although the market for e-cigarettes is very small for now - in terms of both, volumes and revenue - it has been growing at a very rapid pace. At $1.5 billion in sales, the market for these vapor devices has tripled from around $500 million in 2012. Advertisements, increased awareness and trials, as well as a growing retail distribution are some key factors driving growth in the category. We believe that there is a $5 billion opportunity for Altria in the e-cigarettes market. (See: Altria Could Add $5 Billion In Value By Selling E-Cigarettes)

The global e-cigarettes market is twice as large as the U.S. and has a much higher growth potential in the long run. Philip Morris International is however betting more on the reduced risk products it has been developing over the last few years. These products use heating instead of burning like e-cigarettes, but don't have batteries and use tobacco instead of liquid. During the recent Morgan Stanley Consumer Conference, the company officials announced that test results of their "Platform 1″ products exceeded their expectations and they are planning a commercial rollout in the second half of next year.

The Cross-Licensing Agreement

According to the cross-licensing agreement reached between Altria and Philip Morris International recently, Altria would provide Philip Morris International an exclusive license to commercialize its e-cigarettes internationally. On the other hand, Philip Morris International would provide Altria an exclusive license to commercialize two of its "Reduced Risk" products in the U.S. The two companies also agreed to work together on regulatory engagement related to heated tobacco products with the FDA, and e-vapor products with international regulatory authorities.

For Altria, there would not be any material gains from the agreement until the U.S. FDA allows commercialization of the so-called "Reduced Risk" products. However, it does provide the company with an opportunity to further diversify its already rich portfolio of products, which includes smokeless tobacco products and wine.  This in turn could better insulate the company's earnings growth potential from the declining consumption of traditional cigarettes in the U.S. On the other hand, the agreement provides Philip Morris International with a developed e-cigarette product to sell in international markets, which could help offset the declining consumption of traditional cigarettes due to consumers shifting towards their electronic counterparts. Overall, we believe that the above agreement is a win-win, and improves long term growth prospects of both the companies.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: LO , MO , PM , RAI

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