have we seen this before? - Foundation for a Smoke-Free World

have we seen this before?

Japan Tobacco estimates that domestic cigarette industry volume will decline at a rate of approximately 17.5% in 2018. The forecast is a result of the rapid category shift from combustible cigarettes to Heat-not-Burn (HnB) products in Japan – the pace of which is unusual for any consumer good and historically unheard of within the Tobacco sector. One competitor reports a nearly 14% national market share in the fourth quarter of 2017 with its HnB product, an increase from about 7% in the first quarter. Furthermore, results from Sendai, Japan (where HnB initially launched and multiple competitive products are present) indicate that the heated tobacco category, in a very short period, appears to have taken a nearly 30% share of the tobacco (cigarettes plus HnB) market.

This dramatic shift in the Japanese tobacco market reminds me of my experience in Telcom, as the landline business was usurped by wireless – changing technology, high competition and shifting regulation. I covered the U.S. Telecom industry and companies as an equity analyst beginning in the year 2000, at which point wireless was a growing but still relatively small component of the Telecom pie. In the Telecom example, the incumbents were disrupted by new entrants, the deterioration of the high profit legacy landline business and the implications of starting up the new wireless businesses. Regulation moved from very stringent in the landline case to relatively light touch in wireless. The light touch regulatory scheme, in my view, was a critical component in enabling wireless competition to flourish in bringing new products to market at price points which promoted robust customer penetration and substitution for landline. The wireless product, unlike tobacco, did not have serious doubts raised about its health risk. Then again, I think it’s fair to say few people correctly predicted the innovation, growth and expansion of the wireless industry during the roughly two decades following its inception.

I argue that the winner in the Telecom example is the consumer receiving more utility per telecom/cable/media services dollar. Think about how you consume telecommunications services today – mobility, video, Internet data, voice, etc. – compared to landline local, long distance and basic cable of twenty years ago. What changed? In part, the unleashing of innovation and competition. On the other hand, the companies consist of winners, losers and survivors. Some of the survivors did not necessarily produce superior investment returns, but they survived.

In my Tobacco analogy, combustible cigarettes are equivalent to landline and next generation products (NGP’s) to wireless. Of course, the stakes are much higher regarding tobacco products. However, the potential exists to save lives and end significant suffering by moving people from the old combustible cigarette to new reduced-risk products and alternatives, which have the potential to provide consumers with what they desire without being tied to some of the deadly health impacts of smoking. The ultimate goals are to quit smoking entirely or to never start.

That said, as is the case for Telecom, it is fair to assume the behavior of the Big Tobacco companies is driven by the objective to maximize shareholder value given the numerous challenges they face – in contrast to purely altruistic motives. Therefore, I believe Big Tobacco is trying to maintain its barriers to entry with the introduction of NGP’s, such as heat-not-burn, although short-term share shifts can certainly arise as we are seeing in Japan. The companies would prefer a managed migration from combustible cigarettes to NGP’s over years/decades to manage predictable financial performance, but they cannot fully control regulatory behavior, local competitive responses, technological innovations and consumer demand for the new products. Thinking as a financial analyst, additional risk mitigation factors for Big Tobacco include relatively low capital intensity, local new entrants/technologies could become future acquisition targets, and new reduced-risk products may expand the market compared to the factory-made cigarette only world.

At this point, I think a major uncertainty for the Tobacco companies going forward is likely to be how the regulators around the globe deal with taxation of the NGP’s, which has implications for future corporate profits and consumer adoption. While progress associated with reduced-risk products is being made regarding safety, quality and competitive offers, referring to the Telecom example, consumer adoption will also depend on the regulatory environment (including differentiation in price) and customer knowledge. Pricing regimes not reflective of the risk profile, as well as negative perception and poor knowledge of product benefits versus risks based on the science, could hamper consumer confidence and thereby adoption at this stage. Bottom line, more research is needed quickly such that consumers can make informed choices, and regulators can place the appropriate protections around the products based on relative risk.

In the long run, I think the introduction of new reduced-harm products could be positive for consumers. In my opinion, Big Tobacco will for the most part control the NGP’s market, due to the required capital investment, desire to retain market share and the benefits of scale. But it’s not a given, as innovation and technological change come to the Tobacco industry as never before. It will be interesting to watch the disruption of the industry as new products designed for harm reduction are introduced and awareness of these products is increased.

The demand for combustible cigarettes may or may not decline as rapidly as landline has over the past fifteen years, but it’s a framework – new products, competition and regulation – I am familiar with. I hope to bring a diverse background to the Foundation for a Smoke-Free World. I look to contribute to the identification of solutions for long-standing and complex problems in novel ways by applying objective data analysis of the relevant issues and transparent financial analysis of the companies’ actions and operating results.

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