Cigarette Makers React to Tax Hike

As a result of the hike in federal taxes, two U.S. cigarette manufacturers Altria Group, Inc. (MO - Analyst Report) and Reynolds American, Inc. (RAI - Analyst Report) announced price increases. Currently, the decline in cigarette consumption is approximately 3% to 4% each year. The price increase is expected to drive further declines. Moreover, during a recession, it is difficult to accurately predict the effect on total cigarette volume and pricing, shifts between premium and value priced cigarettes, and the level of migration from cigarettes to smokeless products.

In addition, Altria and Reynolds American already are witnessing continued volume declines along with numerous tobacco liability suits. Although, both companies support the enactment of Tobacco Industry regulation, there are still doubts among people regarding the impact of the tax increase. However, many employees of Reynolds American protested against the proposed tobacco tax hikes.

The new bill SCHIP (State Children’s Health Insurance Program) led to a $0.6166 per pack increase in the federal tobacco tax. Therefore, on a pack of 20 cigarettes the tax was increased from $0.39 to $1.01. Tobacco tax increases of this scale are experienced for the first time. In the first quarter of 2009, industry cigarette volume declined 10.4%, primarily due to the wholesale inventory reductions related to the tax increases. According to the recent Fitch report, the industry volumes are expected to decline further by 3.5% to 7.0% during the year.

We currently rate a Hold on Reynolds American and Altria, as both the stocks maintain a low P/E due to tobacco-related litigation issues, and court case losses.