When the world’s largest tobacco company announced in 2007 that it planned to break in two, the rationale was that its US and international operations faced fundamentally different dynamics.
The split of Altria and Philip Morris International, which took effect in 2008, would free a faster-growing international division to pursue the emerging markets consumers who were trading up to premium brands such as Marlboro from the US operation whose growth had been hobbled by years of litigation and was staring at an inexorable decline in the number of smokers.
That the two companies are exploring a merger little more than a decade later speaks to profound changes in their marketplaces, technologies and attitudes towards their core product.
The biggest of these is what Wells Fargo analyst Bonnie Herzog described as a “global arms race for reduced risk products”. After decades of fruitless and sometimes halfhearted investments by tobacco companies, two alternative technologies are showing signs of persuading cigarette smokers to switch to something less harmful. Altria and PMI have a substantial interest in both of them.
In the past decade, PMI has invested $6bn — more than any other tobacco company — to develop a product that heats tobacco for a cigarette-like experience that exposes smokers to fewer harmful chemicals than burning the leaf does.
Iqos, its third attempt at creating such a product in 20 years, has performed well in Japan and other Asian markets, converting more than 7m smokers. But its biggest test awaits: Altria had planned to begin testing Iqos in Atlanta next month, with a view to rolling out sales across the US.
That arrangement would have seen Altria license the technology from PMI. But under the common ownership the merger talks are aiming for, PMI would have access to the full economic benefits if Iqos took off among the 40m adult smokers in the US, Ms Herzog noted.
Altria has made its own $13bn bet on an alternative to cigarettes. The US company took a 35 per cent stake late last year in Juul, putting a $38bn valuation on the fast-growing company that has seized more than 70 per cent of the US ecigarette market and has an explicit mission of ending cigarette smoking.
The deal gave Altria exposure to the most successful of the “vaping” start-ups, having failed with its own ecigarette investments. The appeal for Juul was the prospect of Altria using its vast marketing and distribution power to promote the Juul brand from Marlboro packets to retailers’ shelves.
This promise was “transformational” to Juul’s mission, according to Dan Thomson, managing director of Juul’s UK arm: “We’ve got the biggest manufacturer of cigarettes in America to hasten their own decline, or hasten the decline of their existing cigarette business,” he said.
A combination of Altria with PMI could give Juul a similar boost in international markets and provide the new tobacco company with an unrivalled slate of alternative products, effectively spreading its bets about the future of smoking.
Bernstein Research analysts cautioned that non-compete clauses could restrain any plan for PMI to promote Juul internationally, but Robert Waldschmidt, a strategist at Liberum, said that bringing together the leading ecigarette business with the leading heat-not-burn brand would make the combined company a dangerous competitor for tobacco rivals.
“I expect the existing incumbents of Imperial, BAT and Japan Tobacco will need to revisit their playbooks for M&A and value creation,” he said.
Tobacco executives now say such alternatives can be as profitable as cigarettes after a period of high marketing investment to establish the new brands. That realisation has encouraged companies including PMI and Altria to see their strategy as trying to take market share away from cigarette rivals without such products.
The litigation concerns that hung over the Altria/PMI split more than a decade ago have also ebbed. It is 21 years since the then Philip Morris and its rivals agreed to the largest civil litigation settlement in US history, guaranteeing $206bn in payments to 46 states over the next quarter-century. But the industry has continued to produce prodigious returns to shareholders.
However, the fact that shares in Altria and PMI were under pressure after the companies disclosed the talks on Tuesday underlines the task they face in convincing shareholders that a deal is the best way to address the disruption the industry faces.
One of the biggest hurdles in the path of a successful PMI-Altria recombination is the uncertainty about how regulators will treat the new products on which the industry’s growth depends.
In April, the US Food and Drug Administration authorised Altria to start selling PMI’s Iqos heated tobacco system in the US, but analysts are concerned that the regulator could clamp down on the ecigarette market, after warning of an “epidemic” of youth vaping.
Ryan Tomkins, an analyst at Jefferies, said that the biggest threat to the deal was the FDA, which has focused its efforts to curtail vaping on Juul in particular due to its popularity among teenagers and is investigating reports tying seizures to vaping use.
Mr Tomkins added that a Centers for Disease Control and Prevention survey of youth tobacco use in the US was due out any day, “the results for which could be dangerous for Juul”.
Since their split, PMI and Altria have also diverged in other ways. Altria, led by Howard Willard, last year took agreed to take a C$2.4bn stake in the Canadian cannabis company Cronos, but PMI chief executive André Calantzopoulos has said he still sees too many risks in a market where international regulators have found no consensus.
More profoundly, the two companies have differed in their commitment to killing off their main product. PMI talks about “building a future on smoke-free products”. Altria has framed its stance more cautiously, emphasising smokers’ “consumer choice” alongside its commitment to innovation and harm reduction.
Stifel analyst Christopher Growe said a merger would boost PMI’s earnings and extract $400m in savings, but Altria’s higher regulatory burden and slowing growth would reduce the multiple at which PMI’s shares trade.
That concern drove PMI’s shares down almost 11 per cent from Friday’s close by Tuesday lunchtime in New York, pointing to the potential that investors’ concern could yet prove the biggest obstacle to the deal.
If it does happen, however, it could be just be a prelude to another split, Mr Growe speculated: “Perhaps this merger would allow the combined company to create two separate businesses — one focused on cigarettes and generating strong free cash flow and one focused on growth with new, innovative products such as Iqos and Altria’s stake in Juul.”
Additional reporting by James Fontanella-Khan in New York
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