Thursday, March 9, 2023

Will "nicotine as a service" be as lucrative as cigarettes were?

Wanted to expand on this week's post about Altria's Bungles because we have been rethinking the tobacco trade more generally. Recall that in order for the big tobacco basket to work as an investment, we needed two things:

  1. "Re-nicotinization," where the number of people using nicotine (in whatever form) stops declining and preferably grows.
  2. A growing nicotine industry profit pool, with the vast majority of it captured by big tobacco: MO, PM, and BTI.

We are still confident in the first proposition. We see plenty of happy Zyn customers. We also see plenty of people vaping.

When oil prices spiked last summer, it hurt cigarette sales. However, when oil prices declined through the end of the year, cigarette sales did not recover or bounce. At Altria, cigarette volumes were down 11% year-over-year in the second quarter of 2022, and down 12% year-over-year in the fourth quarter

BTI's U.S. cigarette volume was down 13.4% in the first half of 2022, and was down 15.5% for the full year. If you back out the first half, that means that the U.S. combustible volumes were down 17% for the second half of 2022 vs 2021. 

What happened? We wonder whether high gas prices were a catalyst for some smokers to switch to a reduced risk nicotine product and quit cigarettes. That would explain the lack of a bounce after gas prices fell. If that is true, there is a negative asymmetry in the cigarette business; a one-way ratchet where bad circumstances push smokers away from cigarettes and nothing brings them back.

Why is it bad that people are quitting cigarettes? Wasn't that our "re-nicotinization" thesis? Yes, but that was assuming that the reduced risk product profit pool would be as big or bigger than the cigarette profit pool, and that it would be captured by the incumbent tobacco companies.

The cigarette business is basically a duopoly, hence very profitable. The reduced risk products have tons of competition. When we see people vaping now, we often see them using cheapo, open-tank products. The telltale sign is when the billowing smoke cloud smells like something like fruit or candy.

It is concerning that the big tobacco companies have growing sales of reduced risk products, yet the only reduced risk products that seem to be profitable are Zyn in the U.S. and IQOS in Europe. BTI lost 400 million GBP last year in "new category" (reduced risk products) on 2.9 billion GBP of sales. Altria's only reduced risk product before the NJOY acquisition is the "on!" nicotine pouch, which is almost certainly a money loser.

It is seeming possible that re-nicotinization is happening, but that the nicotine as a service business is going to remain fragmented enough such that the profit pool that used to exist in cigarettes is substantially diminished. 

Big tobacco is at a disadvantage in vaping because it has been playing by the rules. If you can only sell tobacco flavored vapes, you are going to lose out to "disruptors" who do not follow the rules and can sell watermelon or cotton candy flavored ones. BTI's U.S. subsidiary has asked the FDA to crack down on the illegal vapes, but they are still for sale. Can the FDA stop strip mall vape stores and gas stations from selling Chinese vaping trinkets to willing buyers? It's an open question. They do not have a police force.

And even if they can, what assurance do we have that the authorized reduced risk nicotine market is going to be a profitable duopoly the way that cigarettes were?

The premarket tobacco applications (PMTAs) required by the FDA were onerous, but not so onerous that only big tobacco companies participated. They received applications for millions of products. So far, they've approved products created by Japan Tobacco, NJOY, British American, and Philip Morris, and presumably will approve more. 

Also, once they have gone through all of the PMTAs and it is clear what kind of product they will accept, what stops competitors from launching me-too products that are also FDA authorized, so that they can grab some of the fat margins? (And perhaps the illegal black market open tank products are here to stay as well.) If you recall our original tobacco post from 2019, the idea was that big tobacco would have sufficient regulatory capture to have a moat around reduced risk nicotine products. 

Instead, reduced risk nicotine products are seeming like a free-for-all. If true, that would mean that the glory days of tobacco profits are going to come to an end.

It has been a good run. Since our post, "What I Would Buy Instead of Tesla" in October 2020, Altria is up 42% and has paid significant dividends. The performance of Philip Morris and British American has been even better.


Anonymous said...

Sounds like you are throwing in the towel on MO.

MO may have been set up by the loathsome regulators, I don't trust the Feds, take a look around for proof.

If I was MO I would immediately stop selling cigarettes in hostile tax states, like now, just go to a cigarette based company, pay down debt maybe sell BUD like you suggested and wait, pull in the horns wait until there is new leadership in Washington.

KJP said...

I think you can add Velo in Europe to the list of profitable RRP products. For most of BAT's RRPs, revenue increased much more than volumes in 2022, indicating that they're lowering RRP losses by raising the prices of previously unprofitable products. But Velo Europe did not have that dynamic -- revenue and unit growth were essentially the same: "In Europe, we remain the volume share leader in 15 Modern Oral markets, with revenue and volume growth at 30.8% and 29.9%." Velo is also dominant in Scandanavia and pouches don't suffer from the same competition (lawful and unlawful) facing vape products. So, I think you can safely add Velo Europe to the list of profitable RRPs. I understand Velo Europe is much different than the Velo-branded pouches that failed in the US. BAT either has already filed or will file a PMTA to brings the European Velo pouch to the US market.

On your broader point, I agree that the ability to maintain regulatory capture with actual enforcement of the rules is key. I think that will happen in pouches and heat-not-burn products like IQOS. Vapes is much less clear, which seems a bigger problem for BAT given its focus on Vuse in the US. All the more reason to get Velo Europe to the US as soon as possible.

CP said...

Thanks for the comments. Here's what I'm concerned about:

Cigarette smokers are quitting when their budgets get tight, and not coming back. (For example, when gasoline prices declined after the spike last summer.) The declines in U.S. cigarette volumes at Altria and British American in the fourth quarter were horrific, although they were able to offset the effect for now by raising prices. But there is a limit to how long that will work; they can't sell one cigarette for $50 billion.

When the price-sensitive cigarette smokers quit, they seem to gravitate towards the illegal products. There's no moat around big tobacco's vapes: if anything, the illegal products are BETTER than big tobacco's products because they have flavors. No one would start a new brand of cigarette, but people are eager to try their hand at a vape. The result is market fragmentation instead of a highly profitable duopoly.

Nothing says that the provision of nicotine to consumers will be inherently high margin. A duopoly with brand loyalty was very profitable. There's no reason to think that a fragmented market will be as profitable.

Because of the competition from cheapo illegal open tank products, and legal authorized vapes, there may be a limit to the ability to raise the cigarette price to offset volume declines. If that were to happen, the value of the cigarette businesses would be re-rated sharply downwards. (This happened before, on Marlboro Friday, "the day the Marlboro man fell off his horse":

AllanF said...

Nic isn't profitable. A duopoly is profitable.

The midwit shrews at the FDA literally hate nic. So they are doing everything they can to slow-roll RRP.

And they are lazy. So they are going to go after the big and easy targets, MO & BTI, and, except for jawboning about it, ignore the millions of cheap disposables pouring in from China.

So Big Tobacco are like the ILEC's. The land-line business is in run-off and the new thing, internet, isn't going to save them because it's not a monopoly anymore.

To be sure, ILEC's had a nice run a lot longer than most people thought they would, but in the end it was a dying business. Big Tobacco, likewise, has had a nice run the last 20 years, but its end is (finally) rapidly approaching.

AllanF said...

LOL. I wrote all that then hit publish, only to see CP's comment. Yes, we agree.

CP said...

Thanks, AF - they don't seem to have the willingness OR the ability to do anything about the illegal vapes.

As one good CBS friend says, they don't even have the ability to stop fentanyl!

AllanF said...

LOL. I almost made a fentanyl comparison too.

CP said...

Great minds...

Need investments where sclerotic soybrained boomer inertia helps you, not hurts you...

CP said...

More Americans now favor legal cannabis than legal tobacco, surveys show, signaling a sharp societal shift from an era when cigarette-smoking was legal pretty much everywhere and pot-smoking was legal absolutely nowhere.

CP said...

New 5th Circuit ruling in favor of RJR (BTI), staying an FDA denial:

It is common knowledge that by Summer 2021, the FDA unexpectedly found itself inundated with millions of PMTAs. To speed up application processing, the agency circulated an internal memorandum providing a new “standard of evidence” for some PMTAs for flavored e-cigarettes. The standard should sound familiar: PMTAs now require evidence from a randomized controlled trial or long-term study, along with “strong evidence that the flavored products have an added benefit relative to that of tobacco-flavored ENDS in facilitating smokers completely switching away from or significantly reducing their smoking.”9 FDA, PMTA Review: Evidence to Demonstrate Benefit of Flavored ENDS to Adult Smokers (Aug. 17, 2021); see also Timothy Donahue, Lawsuits Focus on FDA’s ‘Fatal Flaw’ Review for PMTAs, Vapor Voice (Nov. 19, 2021), (linking to “fatal flaw” memoranda); Alex Norcia, FDA Memos Reveals Its “Fatal Flaw” Rejection plan for Flavored Vapes, Filter (Nov. 3, 2021), Every PMTA that did not include the requisite new evidence was denied. The result: not a single PMTA for non-tobacco-flavored e-cigarettes has been granted.

CP said...

A landmark trial kicking off next week will decide whether Juul and Altria Group, Inc.'s vaping products and marketing to young audiences violate a legal theory that’s driven multibillion-dollar settlements for opioid makers, distributors, and retailers.

This Monday Minnesota’s first-of-its-kind trial against the electronic cigarette and tobacco giants begins in a case that could strengthen the public nuisance theory—a flexible claim allowing suits against businesses that allegedly create societal harms ranging from environmental spills to public health epidemics.

It’s the same theory used to combat the cigarette industry in the 1990s. Notching a win here could give states leverage to force settlements with vaping manufacturers—a step dozens of states have already taken with Juul. However, a loss could strengthen industry’s hand in potential litigation against Juul or other companies.

CP said...

RJRV demonstrates that the FDA failed to reasonably consider the company’s legitimate reliance interests concerning the need for longitudinal studies and marketing plans; failed to consider relevant evidence, inter alia, that youthful users do not like menthol-flavored e-cigarettes; and has created a de facto rule banning all non-tobacco-flavored e-cigarettes without following APA notice and comment requirements.