In the open-air Fulton Mall shopping promenade in downtown Brooklyn, N.Y., mom-and-pop florists and nail shops have long co-existed with national retailers such as Macy's (FD ) and Toys "R" Us (TOY ). Recently a new type of purveyor has arrived and thrived: strolling salesmen with shopping bags and a furtive pitch: "Newports. Marlboros. Five dollars."
With legit retailers charging as much as $7.50 a pack in the most expensive markets such as New York City, where state and city taxes alone add on $3 a pack, the nation's gray market in cigarettes is growing fast. And no one has been hit harder and faster than Philip Morris Cos. (MO ), the largest and most profitable global cigarette company and maker of Marlboro, the country's No. 1 cigarette brand. Until recently, the company had continued to roll along almost undisturbed, cranking out 8% plus earnings gains despite a tough economy, rising excise taxes, growing legal expenses, and the cost of funding its share of the industry's $10 billion-a-year settlement with state attorneys general.
No more. These days, the tobacco giant is a lot less bullish. As recently as Sept. 24, Philip Morris predicted earnings would grow by 8% to 10% in 2003. But on Nov. 12, Michael E. Szymanczyk, CEO of Philip Morris' U.S. unit, told analysts and investors that it would no longer stand by that prediction. With smoker litigation, long the No. 1 worry for Philip Morris investors, suddenly taking a backseat to earnings jitters, reaction was swift. The stock slid from $43 a share to $37 that day, a 14% drop, and now trades at $38. "Litigation is always going to be a worry, but I think it will be manageable," says Morgan Stanley analyst David J. Adelman. "The fundamentals have become such a greater concern."
Such words are next to unheard of when it comes to Philip Morris. The company has 62% of the U.S. premium cigarette market and 22% of overseas sales, excluding China. It has raised its dividend 35 times in 33 years, and only in two years has the company failed to raise it. Addiction has also been a heck of a business model: Free cash flow, which hit $7 billion last year, should also rise. Philip Morris is one of the few big companies to have barreled through the slowdown virtually unscathed. Analysts expect Philip Morris to earn $9.7 billion this year, a 4% gain from 2001.
So what went wrong? Start with the 12 cents-per-pack price hike the company imposed last March in an attempt to boost profits, a move even its fans question. In retrospect, it looks much too large, especially since the company failed to soften the blow to consumers with even a penny of additional promotional spending, in the form of coupons or other discounts. "Part of what's happened is of Philip Morris' own creation," says Robert Campagnino, an analyst with Prudential Securities Inc. who continues to rate the stock a buy.
Yet part is not. Across the country, cigarette taxes are skyrocketing. In the past year 20 cash-strapped states have hiked excise taxes on cigarettes, helping to push the average price of a pack of Marlboros to $3.80 this fall before the company frantically began discounting. Together, taxes and Philip Morris' own price hikes appear to have sparked a big jump in discount cigarette sales this year.
With discount brands averaging just $2.40 a box, smokers--long thought to be virtually price-insensitive--have finally said ouch. Discount brands such as Commonwealth Brands' USA Gold have had strong sales, as have mid-tier brands like Brown & Williamson's Pall Mall Filtereds. Coney Elliott, who runs Kent Oil's 22 convenience stores in West Texas, says his best-selling discount brand, Carlyle--which goes for half the price of Marlboro--outsold its branded rival in October. That's the first time in five years that Marlboro wasn't his top seller. "People are receptive to other brands," says Elliott. "They're counting their pennies."
Smokers are also shopping at discount shops. At the Akimel O'Othham Smoke Shop in Gila River, Ariz., manager Robert Gaitan expects an impending excise-tax jump to have smokers lining up to buy cheap before the hike kicks in. At stores like his, which are located on Indian reservation land, smokers get an additional price break by avoiding Arizona's 8% sales tax, a savings of $2.75 on a full-priced carton of a premium brand.
That's not Philip Morris' only problem. Many who still want name-brand smokes are buying them from international Web sites such as www.yessmoke.com, where a carton of Marlboros goes for half the U.S. price, plus just $2 for express shipping. The reason they're so cheap? Some offshore sites buy inexpensive Marlboros made overseas for less than the U.S. wholesale price, hurting Philip Morris' bottom line in the process.
Moreover, while the Internet accounts for only 2% of sales today, it's clearly a growing threat. Forrester Research Inc. in Cambridge, Mass., predicts online tobacco sales will grow from $750 million last year to $5 billion in 2005. And cheaper gray market smokes isn't the only reason the Web threatens Philip Morris. Discount brands also get equal footing with the big names on most sites, making their appeal--and their price advantage--perfectly apparent.
Szymanczyk is now moving forcefully to contain the damage, cutting 15 cents off a pack of Marlboros in the past month. Even sharper discounts are planned for the rest of the year, retailers say, and the company has filed suit against some sites based on copyright infringement and other issues. It is also helping the state attorneys general to investigate discount cigarette makers suspected of keeping prices low by not putting aside the money required by the 1998 settlement between the industry and the states.
That all costs money, however, and analysts doubt the company will be able to cover the outlays with price increases next year. Another dividend hike also looks increasingly unlikely. In remarkably short order, old reliable has become no sure bet.
By Nanette Byrnes, with Mike France in New York