US Tobacco Companies: Minorities, Menthol Keys To Growth

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Most major US tobacco companies announced price increases of about 7 cents per pack of cigarettes late last month. “Overall the cigarette promo decreases/list price increases that Lorillard Inc. (NYSE:LO), Altria Group Inc (NYSE:MO) and now Reynolds American, Inc.(NYSE:RAI) have taken are positive and indicate continued pricing power,” said Bonnie Herzog, managing director of tobacco, beverage and convenience store research at Wells Fargo Securities LLC. “Given that consumption will likely continue to decline in the mid-single-digit range, pricing is necessary to drive topline growth.”

Tobacco companies’ shares underperforming

Regardless of price increases, tobacco companies’ shares have under-performed compared to the S&P 500 (INDEXSP:.INX) index over the last month as shown in this chart below.

Meanwhile, a sluggish US tobacco market and falling demand overseas have pushed tobacco majors towards e-cigarettes. Lorillard’s growing e-cigarette volumes are leading Altria and Reynolds American to consider similar products of their own. Philip Morris International Inc. (NYSE:PM) has been downbeat on its future performance due to weaker international demand, and also announced intentions to enter e-cigarettes.

Is it all doom and gloom for US tobacco?

Silver lining for tobacco companies

The recent 2012 data from the National Survey on Drug Use and Health (NSDUH) has thrown up interesting insights into cigarette consumption trends in the US.

Smoking trends in minorities on the rise

“We’ve continued to see demographic shifts among U.S. adult smokers as the absolute number of African-American adult smokers has increased at a 0.4% CAGR over the last 10 years, while the Hispanic adult smoker population has increased at a 0.3% CAGR (such that these groups each account for 12% of the total population of adult smokers),” say Citi analysts Vivien Azer and Geoffrey Small in their study “U.S. Tobacco – Ethnic Trends and Market Shares in the U.S. Cigarette Industry,” based on the NSDUH data.

2-demo-trends tobacco companies

Graphically, the change in smoking patterns amongst various population segments can be seen here.

3-pie-charts tobacco companies

Menthol cigarettes increasingly popular

Interestingly, the catalyst for the rising cigarette consumption by the minorities appears to be the popularity of menthol cigarettes, according to data gleaned from the NSDUH data by the Citi analysts, which shows a healthy 10-year CAGR for this segment.

“Menthol’s share gains among Hispanics (+23 pts, to 47% over the last decade) and African-Americans (+14 pts, to 84%) make it clear that this segment offers the most concentrated exposure to the portion of the U.S. population that is posting the most favorable cigarette consumption trends,” assert the Citi analysts.

Citi’s ratings on major tobacco stocks

Citi reiterated Buy recommendations on Altria Group Inc (NYSE:MO) and Reynolds American, Inc. (NYSE:RAI) with price targets of $42 and $58 respectively. Lorillard Inc. (NYSE:LO) is rated at Neutral and a price target of $52.

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