Tobacco companies aim to diversify into new image. US sales are down, but cigarette makers sitting on cash hoard
AFTER decades of dabbling in non-tobacco businesses and products, big American tobacco companies are getting serious about diversifying away from the king of cash crops. Jello Gelatin Pops, Oreo cookies, Swingline staplers, Titleist golf clubs - each is a small segment of the tobacco industry's new look - exchanging wreaths of smoke for the image of a diversified consumer products company.
The reason is simple. Cigarette sales in the United States fell 8.8 percent from a 1981 peak of 640 billion cigarettes to 584 billion last year. That is disturbing to industry executives bred to the stability of gradually rising demand.
``I wouldn't call tobacco a dying business, but it is declining,'' says Emanuel Goldman, an analyst with Montgomery Securities in San Francisco. ``The companies see this happening, and they are not about to wait around. I think they have every intention of moving very aggressively on the acquisitions front.''
But even though cigarette demand has fallen in the US, it has gone up overseas. When growing US exports to Japan and Europe are included, industry production was flat, not down, the companies say.
Profits, on the other hand, have been anything but flat. Tobacco products, such as cigarettes, are extremely lucrative and have become more so in the past five years due to price increases and greater production efficiencies. Value Line Investment Survey estimates that even while sales were falling, profits per 1,000 cigarettes climbed from $4.25 in 1981 to more than $9 in 1986, a compound annual growth rate of 16.5 percent.
Wall Street recently turned bullish on tobacco stocks after investor worries about product liability suits cooled in the wake of two major consumer product liability judgments handed down in federal courts in Atlanta and Boston. The suits, which alleged the products were inherently dangerous, were decided in favor of the cigarette companies. Says one analyst, the decisions seem to have established a legal principle that amounts to ``caveat smoker'' - laying the responsibility for smoking and reading printed warnings on cigarette packages on the individual smoker.
Contrary to public perceptions, the tobacco executive's main concern in the 1980s' is not so much his product's potential vulnerability to class-action lawsuits, but rather, the need to find innovative ways to spend surplus cash. Because of tobacco's declining US sales, most of the surplus has to be spent in other, non-tobacco businesses that are growing.
``They are basically buying other companies because of the generation of large amounts of excess cash,'' says Roy Burry, a tobacco industry analyst with Kidder Peabody & Co. ``They want to reallocate this capital somehow. They don't want to put it into T-bills or pay off debt, so they are making acquisitions.''
Philip Morris Companies Inc., for example, has the pleasant problem of figuring out what to do with excess cash (above and beyond expenses) being produced at the rate of $130,000 an hour - $3.2 million a day, or $1.2 billion a year, says Montgomery's Mr. Goldman.
He predicts the cash surplus at Philip Morris will increase by about $400 million a year for the next several years, giving it $8 billion of available cash over five years. Borrowing money in addition to that cash hoard would easily make it possible for Philip Morris to make two good-size acquisitions (in the $5 billion range) in five years, Goldman says.
Tobacco executives acknowledge the motivation to move into other products, but say diversification has long been a goal of the industry and that there is no accelerated plan due to stagnating cigarette sales or legal challenges. They strongly deny any conscious effort to move away from the tobacco business, and point to large capital investments in cigarette manufacturing plant and equipment.
``We've been diversifying since the 1950s,'' says David Fisher, vice-president for public relations at R.J. Reynolds Tobacco USA, a unit of RJR Nabisco Inc. ``Now the corporate focus has narrowed to tobacco and foods, and we are continuing to build on that.''
Mr. Fisher points to RJR Nabisco's $2 billion investment in its Tobaccoville, N.C., facility. That single 27-acre plant can produce 110 billion cigarettes a year. New equipment can turn out 8,000 cigarettes a minute versus 4,000 on old equipment.
``We would not invest that much on an industry [cigarettes] over 10 years and not expect it to be viable down the road,'' Fisher says. ``The fact is that we have been able to invest $2 billion in tobacco and still diversify elsewhere. You can only invest so much in tobacco, then you've got to put your money to work elsewhere.''
Brennan Moran, a spokeswoman for the Tobacco Institute, the industry's Washington lobbying arm, says lawsuits and product liability questions have not spurred the diversification moves of tobacco companies.
``The companies have been diversifying for an awfully long time - a couple of decades,'' Ms. Moran says. ``Companies don't put billions of dollars back into a business they are going to walk away from.''
But if liability suits were not the persuader, it seems growing public disapproval of smoking has been a new spur to diversification. Some analysts say smoking is becoming less chic among trend-setting segments of the public. Though sales overseas seem to be increasing, analysts say there is no substitute for losing portions of the US market, where profit margins are highest.
That fact has not been lost on the big six tobacco companies - Philip Morris, RJR Nabisco, Brown & Williamson, Lorillard, American Brands, and Liggett & Meyers.
Leading the pack, Philip Morris and RJR Nabisco, the world's two largest tobacco companies, have plunged ahead with diversification. R.J. Reynolds plunked down $4.9 billion to buy Nabisco in early 1985, then changed its name to include Nabisco. Philip Morris followed suit, purchasing General Foods later that year for $5.6 billion. American Brands recently reached a $600 million agreement to purchase Acco World Corporation, the office products company.
``Nobody's going to admit that they are buying other companies because they see their own business deteriorating - but the truth of the matter is that is what is happening,'' says George A. Thompson, tobacco industry analyst with Prudential-Bache Securities.
Mr. Thompson's belief that the new acquisitions are a hedge against future declines in tobacco seem to be supported by numbers. Tobacco is so profitable it outshines all non-tobacco acquisitions, yet the bulk of free cash is flowing the opposite direction - towards non-tobacco products and away from the most lucrative end of the businss.
Last year, for example, office product sales produced a 5 percent operating profit margin for one tobacco company. Food products yielded about 7 percent profit margin for another. Liquor yielded 15 percent for another. But tobacco products, for at least three of the top companies, yielded margins in excess of 30 percent.
None of the acquired non-tobacco businesses are as predictable or lucrative as selling little paper tubes filled with shredded tobacco leaves. But cereal, golf clubs, and life insurance are much less likely to draw lawsuits or cause widespread health concerns.
``These companies continue to be faced with the dilemma of having an extremely profitable and predictable product line [tobacco] that has a lot of political risk associated with it,'' says Robert H. Miles, a former business professor at Harvard University who has studied the tobacco industry.
``In terms of revenue dependency, they are shedding the tobacco business fairly rapidly,'' Dr. Miles says. ``But if you looked at their dependence in terms of profits, they are still highly reliant on that business for the bulk of their profits.''
Looking at operating revenues compared with operating profit at Philip Morris and RJR Nabisco [see charts], it is clear that tobacco leads the way in profits, even though the bulk of revenues has moved to new businesses since US cigarette sales turned down in 1981.
``They're really not diversifying or moving out of tobacco at all,'' says Mr. Burry, taking a contrarian view. ``Tobacco profits are growing, and the total revenues are growing. Keep in mind the tobacco business is growing worldwide for these companies. You've got to look at it worldwide of course, because American cigarette consumption is moving down.''
Burry's view is echoed by industry executives who point to the promise of new overseas markets.
``The Japanese have opened up their markets significantly to US imports in recent months,'' says Guy Smith, vice-president for corporate affairs at Philip Morris. ``Export sales are particularly positively affected by the Japanese market. Most places in the world don't have the kind of hysteria we have in this country.''
Some analysts, however, don't see overseas sales replacing lost domestic sales. Profit margins are about half those of domestic sales, and political resistance to any product perceived to be a potential public health risk will be stiffer than in the US.
``Most countries are not going to face an unnecessary public health issue,'' Prudential-Bache's Mr. Thompson says. ``It's fine to sit around and say orientals smoke twice as much as caucasians do, and you know there are 1.2 billion Chinese. That makes great copy, but is it realistic to assume that either the Japanese or Chinese governments will stand for an unnecessary public health problem? I think the answer is probably no.''
Some governments, like West Germany, have enacted stiff excise taxes on cigarettes to gain revenue while deterring smokers. Underdeveloped nations, on the other hand, are seen by analysts as less likely to block or deter smoking, lacking public information on associated health risks.
If the heightened pitch of diversification continues, analysts say tobacco companies will soon be getting most of their profits from non-tobacco product lines.
``Reynolds and Morris are going to be some of the great, broad-based consumer products companies by the end of the decade - that's clear,'' Goldman says. ``It's clear that they have every intention to diversify. When they get done they will not look the same.''
A chart in yesterday's Monitor incorrectly stated the positions of RJR Nabisco and Philip Morris within the tobacco industry. Philip Morris is the largest US cigarette manufacturer, and RJR Nabisco is ranked second.