Tobacco Manufacturing Industry Analysis
By
Brandon Detweiler, Chris Holt, Michael McGee
Table of contents
Part I: Two Publicly Traded Business Rivals……...…………………………………………………….2
Part II: Opportunity………………………………….…………………………………………………...2
1. Industry Description…………………………………………………………………………2
2. Industry Demand……………………………………………………………………………..4
Part III: Industry Analysis………………………………………………………………………………..4
1. 5 Forces………………………………………………………………………………………..4
2. Low Power Forces……………………………………………………………………………7
3. Key Success Factors………………………………………………………………………….7
4. One KSF……………………………………………………………………………………....9
Part IV: Strength Assessment………………………………...…………………………………………10
1. KSF Calculations……………………………………………………………………………10
2. Distinctive Competency Scores…………………………………………………………….11
3. Average Distinctive Competency Scores…………………………………………………..11
4. Summary…………………………………………………………………………………….11
Bibliography……………………………………………………………………………………………...12
1
Part 1: Describe Two Publicly Traded Business Rivals
1.
This paper discusses two of the largest tobacco companies in the world, Altria Group and
Reynolds American Incorporated. Altria Group is located in Richmond Virginia at 6601 West Broad
Street (Altria). Mike Szymanczyk, who is the Chairman and Chief Executive Officer of the Altria Group
said, “Altria understands that industry leadership means more than just financial strength and brand
performance. Our companies have a history of taking proactive and voluntary actions that have changed
the way the tobacco industry operates. With continued guidance from Altria’s Mission and Values, our
companies can discover more ways to responsibly grown and succeed.” Reynolds American Incorporated
is located in Winston Salem North Carolina at 401 North Main Street (Reynolds American). The
President and Chief Executive Officer of Reynolds said, “Given the significant health risks that have been
associated with the use of tobacco, many people would argue that tobacco and responsible don’t belong
together in the same sentence. In contrary to many beliefs, our companies continue to make a vision as
the innovative tobacco company totally committed to building value through responsible growth.” These
businesses compete in two major markets, Cigar Cigarette and Tobacco-Manufacturers (SIC Code: 212101) and Other Tobacco Production Manufacturing (NAICS Code: 31222901).
Part II: Opportunity
1.
The industry that these businesses compete is the manufacture of cigarettes, cigars, smoking and
chewing tobacco, snuff and bidis (IBIS World). The tobacco industry is in steady incline and the revenue
numbers are astronomically high. For example this was a 465.6 billion dollar revenue business last year,
and the annual growth rate is estimated to increase by about 3 percent over the next 5 years (IBIS World).
Profit margins in this industry are extremely low; but due to the particularly high volume of products sold
within this industry the total profits are exceptionally large. There are many promotional programs that
the tobacco manufactures provide for the wholesalers to promote the products. This past quarter higher
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pricing and key-brand volumes, promotional and pricing efficiencies and productivity gains offset the low
cigarette volume (Reynolds SP 500). A reason manufactures provide such a helpful service to the
wholesalers is because the margins are much lower for wholesalers. Within the industry; 80 percent of
revenue is made by the manufacturer and over the past five years the manufactures have continued to
raise prices (IBIS World).
During the past 10-20 years the falling consumption volumes of the tobacco industry have been
because of rising prices, negative publicity, regulations on where smoking can take place and the greater
awareness within our population on the negative side effects that tobacco has upon our health (IBIS
World). Many countries restrict certain advertisements and mandate a health warning on each pack of
tobacco products. In February of 2009 President Obama signed into law an increase of .62 cents in excise
tax per pack of cigarettes, and significant tax increases on other products (Reynolds American 10k). The
main demand for tobacco products is due to the addictiveness of their make-up (IBIS World). Even
though this industry is in a heap of trouble with regulations, the past five years of the depression have
proved otherwise. Due mainly to stress levels about our economic future this is the first increase in
tobacco sales since 1992 (IBIS World). Behind the addictive properties, stress and depression are the
second largest factors in relation to the reason people buy tobacco products. As the health concerns have
risen steeply in the past years, many nations’ governments have increased the excise taxes. They have
been doing this in order to reduce smoking and it is also a way to generate revenue for the country.
During the past five years excise taxes have increased drastically and it makes up a huge portion of this
industry’s revenue (IBIS World).
Cigarettes are the major product in this industry, making up 90 percent of the total amount of
sales (IBIS World). Cigars are a smaller niche than cigarettes in terms of sales volume, but the overall
increase in cigar smoking has increased much more dramatically than cigarettes over the past 5 years.
The smallest segment of the tobacco industry is chewing and smoking tobacco products. The reason for
this smaller demand is mainly because it is only sold to male customers. But there has been a large
portion of money, which went into research-development and marketing for a new product called Snus
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(Reynolds American). Tobacco companies hope this dissolvable strip will attract a female market and
allow this segment to grow rapidly.
Tobacco products are sold through a number of different channels. The largest sector is
supermarkets and grocery stores (IBIS World). The reason for their larger market share is because of
lower price points and the bulk buying of tobacco products. The second largest channel is convenience
stores. They are so successful because they are usually open twenty four hours a day and seven days a
week. Another reason for their high rate of tobacco sales is because of quickness and convenience to
home locations and locations that customers work. The smallest outlet for tobacco products are vending
machines and online retailers. The online sector is growing rapidly due to the number of increased World
Wide Web users.
2.
This industry is considered to have a demand concentration level at a medium rank. As the
tobacco market shifted its buying and selling procedures in 2001, the market concentration has been
increasing (Altria). For example, British American Tobacco, Brown and Williamson merged with
Reynolds Tobacco in 2004 and Altria Group bought John Middleton, Gallaher Group and Philip Morris.
The geographic region that currently accounts for the largest revenue in the tobacco market is Europe
(IBIS World). The demand in this region is extremely high at 22 percent of the population aged 16 years
or older (IBIS World). This is a steady decline from the 1980 pole that listed this geographic region at 39
percent (IBIS World).
Part III: Tobacco Manufacturing Industry Analysis
1.
In order to implement the most effective business strategy to obtain a sustainable competitive
advantage, it is imperative for managers to analyze the industry to better understand the industry
environment in which the firm operates.
Using Porters Five Forces Model for industry analysis,
managers are able to affectively gauge the intensity of competitive forces against the threats to profit
facing an average firm in the industry. The five competitive forces used to analyze the industry are the
threat of new entrants, the threat of rivalry, power of suppliers, power of buyers, and the threat of
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substitution. In doing this, firms are able to determine the potential profitability and attractiveness of an
industry.
The threat of new entry into the tobacco manufacturing industry is determined to be a low power
threat. The tobacco industry is highly regulated internationally and has recently been placed under the
administration of the U.S. Food and Drug Administration (FDA) in 2009. The FDA has increased
regulation through permits and bonds required to manufacture tobacco as well as imposing advertising
restrictions on tobacco companies (IBIS World). The increased industry costs in combination with
advertisement restrictions make it very difficult for new entrants to establish its own brand. In an even
more drastic example, some countries are even considering banning all colors, logos, and brand imagery
(Kwon 2010). In addition, the tobacco industry has matured and is dominated by a small number of large
firms that have achieved economies of scale. In the event a new competitor enters the industry, economies
of scale enable the established firms to exercise price flexibility and lower their prices to maintain their
market share. In an industry that features substantial start-up costs, a price competition would inevitably
pose a serious threat to a new competitor’s sustainable existence. In addition, merger and acquisition
activity have remained high helping to further concentrate market share between the big players of the
industry. The top players in the industry hold over 75% of the market share, with that amount having
increased over the past five years (IBIS World).
In the tobacco manufacturing industry, the overall threat of rivalry is high. According to the
lecture notes from October 11, 2010, rivalry is considered to be a high threat to profit when there are
more than two competitors of similar size (Young). In the tobacco manufacturing industry, the top four
firms in the industry are all relatively equal in size and hold nearly identical market share percentages
(IBIS World). This makes for intense rivalry because competitors are constantly seeking ways to reach a
competitive advantage over one another to gain market share. The pursuit for an advantage over
competitors can lead to businesses changing their prices of their products or increasing the amount of
capital for product innovation, both of which have a negative effect on profits (Porter). And while there
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are only a few major competitors in the industry, there is a significant amount of brands and products
available to consumers, adding to the intensity of the rivalry (IBIS World).
The power of suppliers in tobacco manufacturing is considered to be a low power threat. As
stated in the class lecture slides from October 11, 2010, a low power threat of suppliers occurs when there
are many suppliers for an industry or the demand for supplies is less that the supplier’s capacity to satisfy
all demand (Young). The materials required for tobacco manufacturing include various types of paper,
cellulose fibers, and a variety of additives. However, the most important raw material used by tobacco
manufacturing companies is tobacco leaves, which are purchased directly through tobacco farmers or at
auction. Globally, the number of tobacco suppliers exceeds demand causing some countries to enforce
contracts to purchase domestically.
In the United States for example, tobacco manufacturers are
contractually obliged to purchase a certain percentage of tobacco leaves domestically (IBIS World).
Although world tobacco prices are expected to increase over the next five years, the vast array of
suppliers available will ensure prices do not significantly affect profit (IBIS World). Additionally,
because manufacturers purchase leaves from farmers there is no change of supplier forward integration.
For the industry of tobacco manufacturing, the power of buyers is moderate. The immediate
market for tobacco manufacturers is wholesalers; however, a majority of tobacco manufacturers have
their own wholesaling operations (IBIS World).
By adding wholesale operations in addition to
manufacturing, the firms are able to successfully hedge themselves by having greater control of
downstream buyers. Buyers of tobacco are also composed of the end consumers. End consumers of old
age often exhibit strong brand loyalty, often allowing producers to do little to ensure sales to older
consumers (IBIS World). However, in light of the current economic downturn, some buyers have turned
to low-price tobacco products. If this trend continues, the profits tobacco manufacturers will surely be
affected.
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The threat of substitution in the tobacco manufacturing industry is considered to be a low power
threat. According to the lecture notes from October 11, 2010, customers not willing to use products from
another industry in place of the current industry represent a low power threat for substitutes (Young). The
market currently does not have another industry that provides substitute products for tobacco. While
there is research ongoing to find safer alternatives for tobacco, consumers simply do not have any other
options for tobacco substitutes.
2.
After performing a five forces analysis, the tobacco manufacturing industry tallied a total of three
low competitive forces. These five forces constitute an overall assessment that a company with no
strengths or weaknesses on key success factors will have an expected profitability on all key success
factors to be about equal to the cost of capital.
3.
The main goals of a business are to create a sustainable competitive advantage over competitors
to achieve superior profitability. To successfully ensure superior profitability, it is imperative for
businesses to focus on the key success factors of the given industry. As defined in the first class lecture
on August 18, 2010, key success factors “are specific resources or activities companies must be good at if
they are to remain profitable satisfying demand and defending against high-power competitive threats”
(Young). For the tobacco manufacturing industry there are several key success factors. These include
legal resources and capabilities, economies of scale, manufacturing efficiency, G* for financial resources
dealing with growth, inventory turnover, and the establishment of brand names.
Legal resources and capabilities are critical in protecting against profit in the tobacco
manufacturing industry. As discussed in the IBISWorld industry report, legal “negotiations are essential
given the number of lawsuits industry producers face” (IBIS World). Tobacco companies are subject to
thousands of lawsuits that claim injuries and death from smoking cigarettes, with settlements accounting
for over 10% of revenue (Altria 10K). The tobacco industry is subject to a wide array of laws and
regulations concerning their marketing, sale, taxation, and use of tobacco products. Legal resources are of
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great importance to assure compliance of all regulations and to defend pending lawsuits that could have a
potentially detrimental effect on tobacco producers. The equation for this key success factor is: annual
financial losses through lawsuits divided by revenues.
With nearly 35% of costs being derived from purchases, it is imperative that firms in the tobacco
manufacturing industry take advantage of economies of scale. “Achieving scale economies through a
large processing operation allow a producer to minimize cost of production” (IBIS World). With the
costs of supplies rising, it is becoming increasingly important for companies to achieve economies of
scale to lower this cost (IBIS World). The equation used to calculate economies of scale is costs divided
by total assets.
The manufacturing step concludes 80 percent of all sales in the tobacco industry but it has the
smallest margin for profit (IBIS World). On Phillip Morris’s and Reynolds’s website it specifically states
that they have to manufacture their products with the most advanced technology. In order for tobacco
companies to sustain a competitive advantage the newest technology for manufacturing has to be in place
because they have to meet the demand from the wholesalers and retailers that are placing orders.
Cigarette manufacturing machines are fitted with a product lifecycle control system, while filter tip
attachments are also fitted with the product lifecycle control system, which are for machine control and
high speed inspection. Manufacturing efficiency is measured by dividing cost of goods sold by revenues.
G* is the index of sustainable growth (Young). With the industry at a mature stage, it is vital for
companies in the tobacco manufacturing industry to maintain growth to ensure sustainable profit and
satisfied investors. Large tobacco manufactures benefit from an infinite number of resources to develop a
large network and a distinct noticeable brand. If companies can collect and invest resources wisely, they
will be able to grow and maintain that level of growth going forward.
Inventory turnover is compared at industry averages, which is about 40 days within the tobacco
manufacturing industry. In order to sustain a competitive advantage the inventory has to be processed
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and manufactured efficiently and effectively. Szymanczyk who is the Chairman and CEO of Altria
Group stated, “The better job we do meeting our compliance obligations, the more successful we are as a
company.” Inventory turnover is calculated by taking the revenues and dividing it by the average
inventory on the balance sheet over the last two fiscal periods.
Establishment of Brand Names is very important in the Tobacco Industry, or any industry for that
matter. Because competition in the industry is high, creating brand loyalty is crucial for future success.
(IBIS World) Under the Brand section on the Reynolds’s website they specifically quote, “R.J. Reynolds
focuses its marketing support on Camel and Pall Mall to accelerate the brands’ market-share growth and
to drive the brands for long-term, accelerated growth and profit” (Reynolds American). Reynolds
American knows that building a recognizable brand name is very important and is directly related to
sales. This is true for all companies. It is expensive to build a brand, but strong brands that can be trusted
will govern the future. (CIC Presidents Institute) The Establishment of Brand Names is calculated by
dividing Marketing Costs by Revenues.
4.
The high power threat of rivalry in the tobacco manufacturing industry means that competition
will frequently reduce price as well as take on added costs in terms of product differentiation (Young).
With both of these actions have negative effects on profit, firms must find a way to protect their profit
without hurting the product features or increasing their price. As shown in the class lecture from October
11, 2010, one way to protect profit in this situation is to cut costs without hurting the product features or
factors that support sales revenues (Young). A key success factor for the tobacco manufacturing industry
that can help to achieve this would be economies of scale. Economies of scale will reduce the cost per
unit produced as the size of production increases. This means that it will help to protect profit against
rivalry by reducing the costs without sacrificing product features. If rivalry were to force the average
price to decrease, “the lower costs of production from economies of scale can be passed to customers as
lower prices, while preserving profit (Young).”
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PART IV: Strength Assessment
1. Key Success Factors Calculations
KSF’s
Altria Group Inc.
Reynolds American
Inc.
Economies of Scale (Costs /
Total Assets)
13,618,000,000 / 36,677,000,000
= 37% (Altria 10k)
7,457,000,000 / 18,009,000,000
= 41% (Reynolds American10k)
G* ((1 – Dividend Payout Ratio)
* ROE)
(1 – 0.796) * 0.788 = 16.1%
(1 – 0.79) * 0.148 = 3.1%
(Altria Stock Report & 10k)
(Reynolds American: Stock
Report & 10k)
Manufacturing Efficiency (COGS
/ Revenue)
7,815,000,000 / 16,824,000,000 =
46% (Altria 10k)
4,485,000,000 / 8,419,000,000 =
53%
(Reynolds American 10k)
Inventory Turnover (Revenues /
Avg. Inv. last 2 periods)
16,824,000,000 / 1,439,500,000 =
11.69 (Altria 10k)
8,419,000,000 / 1,195,000,000 =
7.05
(Reynolds American 10k)
Legal Resources and Capabilities
(Annual Financial Loss Through
Law Suits / Revenues)
220,000,000 / 16,824,000,000 =
1.3%
123,000,000 / 8,419,000,000 =
1.5%
(Altria 10k)
(Reynolds American 10k)
Establishment of Brand Names
((marketing cost/revenues)
(2,673,000,000 / 16,824,000,000)
= 15.9%
(1,413,000,000 / 8,419,000,000)
/ = 16.8%
(Altria 10)
(Reynolds American 10k)
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2. Distinctive Competency Scores
KSF
Altria Group Inc.
Reynolds American
Inc.
Economies of Scale
3
3
G*
5
1
Manufacturing Efficiency
3
3
Inventory Turnover
4
2
Legal Resources and Capabilities
3
3
Establishment of Brand Names
5
5
3.83
2.83
3. Average Distinctive Competency Scores
Average
4. Summary
Altria Group Inc. is the clear leader in the Tobacco Manufacturing Industry. They own 51% of the
market share while Reynolds American Inc, the second largest in the industry, has 19% (IBIS World). It
should come as no surprise that Altria Group Inc. has a higher average competency score than its
competitor, Reynolds American Inc, by a full point. They know full well what it takes to be the leader and
are successful because of this knowledge. Their continued success in these factors will be crucial if they
are to be successful because of the future unfavorable tax environment as well as the more than 8,000
law suits against tobacco manufacturers that are yet to be resolved (Kwon 2010, Nathan Koppel).
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