Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls

As we begin Q3 it’s worth digesting the status of Big Tobacco and where we think it is heading. What’s the outlook on pricing and volume trends, is the industry ripe for consolidation, and what did PM say at its Investor Day that may impact the stock and the group?   July also kicks off earnings season for the group.


The table below lists our current investment ideas as well as a list of potential ideas we are in the process of evaluating (watch list).  We intend to update this table regularly and will provide detail on any material changes.

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - zz tob names


7/18/14  PM

7/23/14  MO

7/24/14  RAI

7/25/14  LO


TODAY, July 2 - VMR Products – E-cig/E-vapor call with CEO Jan Verleur at 2pm EST

July 16 - Ballantyne Brands – E-cig/E-vapor call with CEO John Wiesehan Jr. at 11am EST


Sky-high Valuation. As the charts below show, the subsector is heavily overvalue on a historic basis (P/E at 16.5x versus a 5YR average of 13.1x) with all of Big Tobacco just off their max P/E’s over the period.   Valuation is certainly “rich”, however we have a favorite (Long Lorillard) and believe the group will continue to rise alongside consolidation rumors (likely RAI+LO).

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z2

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z. 33333


Cigarette Volume & Pricing.  As we look to the balance of the year, Big Tobacco forecasts U.S. volumes to fall 3-4% this year, similar to 2013, and an anomaly compared to a more recent historical trend of ~ -1 to -2% declines. PM stated that it sees volume (ex-China) falling -2 to -3% this year. We expect Big Tobacco to continue to push through pricing, here again our favorite is LO.  


E-Cig Volume Trends. U.S. e-cigarette sales fell -6.1%Y/Y in the four weeks ended June 15th, according to IRI. The latest figure marks the second consecutive Y/Y drop (following -2.9% for 5/18/14), and reflects a 5.2% drop in units and 1% lower prices.  We view the recent performance as a reflection of a number of factors including increased product and brand offerings, price competitiveness, increased sales of lower margin rechargable kits, and a consumer shift toward e-vapor consumption.


July marks the beginning of national rollout campaigns for Altria’s e-cig brand MarkTen and Reynolds’ VUSE, which is flooding shelves already occupied by Lorillard’s blu and a handful of strong private national manufacturers (including LOGIC, NJOY, Ballantyne Brands). MO and RAI are offering deep discounts and promotion to get their products in the hands of consumers and, along with LO’s blu, are selling kits at lower price/cartomizer. Finally, we’re seeing signs of consumers shift consumption toward e-vapor products (such as tanks, pens, mods), or a form that’s unlike Big Tobacco’s more cig-alike e-cig offerings.  This cohort is not included in measured channels, most often purchased in vape shops, and consumer preference seems driven on e-vapor’s better experience (drag and flavor offerings) and cheaper price versus more traditional e-cigs.   We’re conducting survey work on these issues and will be interested to present our findings.


Despite an increasing competitive environment, we expect advances in Big Tobacco’s e-cig technology with the roll-out of new kits will help propel the industry in the back half and ease recent sales declines.  



LONG LO.  Our long positioning on Lorillard hasn’t changed since we added it as a Best Idea on 2/26/14. What has changed since then is the addition of a rumor mill that RAI may buy the company – we’re riding LO stock alongside these rumor winds. The most recent news that Imperial Tobacco may be shopping RAI’s menthol portfolio is yet another piece of news that should fill LO’s sails. (our note).


What are the main anti-trust hurdles in an RAI-LO deal getting done?

  • A combined RAI + LO would own ~ 67% of U.S. menthol market.
  • A combined deal would rank as the biggest-ever tobacco merger. Big tobacco is already a highly concentrated industry in the U.S. across the big three – MO has a leading ~51% of market share; a combined RAI + LO would equate to ~ 42% share.   

We suspect RAI may be looking to sell its menthol brands like Kool, Winston and Salem, which equates to around ~5% total market share, however we do not think LO will be imminently purchased and are staying long of the stock until an announcement of an agreement or its long-term fair value of $80/share, whatever comes first.  


 In the box directly below we break out our 5 year EPS estimates for the base business and blu. As we show, the combined business, gets a substantial lift in earnings power from blu (currently the e-cig market share leader at 39.2%), boosting overall CAGR to 20%. In the sensitivity analysis box we offer that even under a punitive scenario in which a 10% discount rate is applied on 5yr forward earnings of $7.50, the stock is north of $80.  Given yesterday’s closing price of $61.11, that’s 31% upside in the stock from here.  

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z4


Below we take a look at the top 10 global tobacco companies by revenue, as a reference for the industry’s biggest players as rumors of further consolidation pang the industry. 

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z.5



PM Investor Day Highlights:

Intermediate Term Struggles Persist; Non-Combustible Investment Significant & Bullish. We are getting constructive on PM over the longer term, especially given its recent move (-8% off its year-to-date high on 6/19). More to follow.

We’re very encouraged by PM’s longer term outlook based on its strong international brand equity, increased R&D spend towards future growth in Reduced Risk Products (RRPs), ability to take price (which it expects to remain in-line with its historical average of $1.8B per year), and easier comps after two years of excessive (above historical norm) excise tax hikes in key geographies (like Australia, Philippines, Japan, Russia, Spain, Italy, France that’s encouraging illicit trade), unique competitive challenges (Philippines and Australia), and macroeconomic weakness, all of which has led to extraordinary volume declines of -3% to -4% per year.


The company did lower its EPS target for 2014 (to $4.87-$4.97 versus previous guidance in May of $5.09-$5.19) to better reflect these intermediate term challenges, however we’re encouraged by its R&D spend (some $2 billion and hiring 300+ scientists since its spin) and focus to lead the RRP category, which we see as a natural progression to declining global cigarette trends:  RRP can offset combustible cigarette declines and grow new product demand, a winning long-term strategy in our view.  


The company also announced the acquisition of Nicocigs Limited (“Nicocigs”), a U.K.-based e-vapor company whose principal brand is Nicolites. The terms of the deal were not disclosed, but Nicolites has a 27% share of the U.K. e-vapor market, and the acquisition gives PM instant sales presence and a 40 person sales team on the ground (the current U.K. retail e-vapor market is estimated at approximately $350MM, the second largest behind the U.S.).  We believe PM’s global inroads and partnership with MO will aid in quickly accelerating brand share and ultimately loyalty, a key component given the early stage of e-vapor product development and increased competitiveness now that all of Big Tobacco has e-cig/e-vapor products on the market. 


Finally, we’re bullish over the longer-term on Marlboro 2.0, the company’s architecture to modernize the brand, and with it expand into new population and smoker segments, catering towards trends of consumers seeking smoother tastes, even within the full-flavor category.  We’re positive on the company’s push to trade up consumers to the premium and above premium categories that enjoy higher margins. This we believe PM can carry out its strategy over the longer term, leveraging strong marketing and sales teams across the globe, and leverage the growth in aspirational consumers seeking the strong brand identities of the PM portfolio.



Below are key bullets from the PM Presentations last week (Thursday and Friday):

On Reduced Risk Products

  • PM calls the segment the “greatest growth opportunity” to address range of adult smoker preferences
  • Invested significantly in R&D behind RRPs (some $2 billion and hired 300+ scientists since its spin)
  • Has portfolio of over 500 patents worldwide and 1,000 patents pending

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z6

  • Platform 1 on track for launch (iQOS and Marlboro HeatSticks) in test cities in Japan and Italy in Q4 2014 with national launch schedule for 2015
  • Factory being built in Bologna, Italy is expected to produce 30B units by 2016
  • iQOS consists of “precisely controlled electrically-heated tobacco system” that maintains a tobacco temperate below combustion, designed to use with a custom “HeatStick” tobacco stick that is to be Marlboro branded
  • iQOS expected to be rolled out across its C-store network
  • Platform 2 (heat-not-burn combustible cigarette with cigarette-like look) expect to launch in 2016
  • Platform 3 & 4: Nicotine containing e-cigarettes/e-vapor products scheduled to launch in 2H 2016
  • According to PM the RRP are expect to negatively impact profits in 2014-2016 (hence the update to its guidance) and tip positively beginning in 2017
  • Announced the acquisition of Nicocigs Limited (“Nicocigs”), a U.K.-based e-vapor company whose principal brand is Nicolites, which has a 27% share of the U.K. e-vapor market. The terms of the deal were not disclosed

Regional Commentary


  • Arresting the volume decline:  now forecasts volume down 5-6% in 2014 vs previous guidance of -6 to -7%.  Expects volume down 5-6% in 2015 and down 4-5% thereafter.
  • Marlboro continues to take share, up 38.9% in 1Q 2014 vs 38.5% in 2013, with 84% of the company EU volume concentrated in four brands: Marlboro, L&M, Chesterfield, and Philip Morris
  • Strategy to drive growth in premium and above premium segment and take price to offset volume declines 
  • Expects excise tax should remain rational, and within bounds of recent years range of 3% - 6%
  • Reduced Risk Products: great opportunity with test launch of Platform 1 in Q4 2014 in Italy and national expansion in 2015
  • Tailwinds: UK untapped market. PM has market share of 38.5% in the EU, but only 7.3% in the UK.
  • Headwinds: Losing share in Spain, Italy and France on hike in excise tax and uptick in illicit trade
  • says 1 in 10 cigs sold in the EU was illicit last year... working to tackle this problem



  • Continues to be a growth engine for the company with 7 of the top 10 smoking countries across the globe located in Asia

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z7


Near term headwinds

Japan, Philippines, Australia, Indonesia, and Russia offer particular challenges, citing the existing unfavorable excise tax and illicit trade headwinds

  • Japan – excise hike from 5% to 8% in April 2014, and another VAT hike expected in October 2015 in the 8-10% range (final word expected near year-end)
  • Philippines – the co. struggles with a major competitor in the Mighty Corporation. In 2013, the company only declared half of revenues for tax purposes, and continues to create an uneven playing field
  • Australia – after a 12.5% excise tax hike in December 2013, there’s another 12.5% hike scheduled for September 2014. Seeing sharp growth of illicit trade (up to 13.9% after years of decline) alongside hit from plain packaging and competitive price discounting
  • Indonesia – PM is the largest player in hand rolled cigarettes, how consumer trends against hand rolled is working against them
  • Russia – challenged volumes on higher excise (most recently in January 2014 of 8 Rubles/pack) and smoking ban in bars and restaurants effective June 2014

Longer term Tailwinds

  • Philippines – government likely to side with PM with tax stamps expect in July 2014 to better even the playing field (vs Mighty) and drive share gains. 
  • Indonesia – significant growth opportunity with increased purchasing power and middle class expansion.

LatinAm & Canada

  • In LatAm the compnay has a huge opportunity through its strong brand equity to gain share of more people moving into the middle class, GDP picking up, and by addressing illicit trade with governments throughout the region
  • Highlights include better price management in Brazil and Argentina; the co.has a great opportunity to growth the Brazilian market (as the chart below shows, Marlboro has only a 8.7% share in the country), and must work to limit downtrading in Mexico

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z8

Tobacco Trends – PM Shorter Term Struggles Persist; LO Bulls - z9


Happy 4th of July!


Howard Penney

Managing Director


Matt Hedrick



Fred Masotta


Macro Notebook 7/2: POUND UST 10YR RUSSELL 2000


Takeaway: Mortgage purchase applications decline for the third week in a row and now point to a sharp and widening divergence vs pending home sales.

Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.


*Note - to maintain cross-metric comparability, the purchase applications index shown in the table below represents the monthly average as opposed to the most recent weekly data point.




Today's Focus: MBA Mortgage Applications

The Mortgage Bankers Association today released its weekly mortgage applications survey data for the week ended June 27. 


We wrote on Monday that the strong Pending Home Sales number for May seemed at odds with the weak June mortgage applications data. We acknowledged, however, that there was still one week left in June that, if very strong, could explain away the difference.


This morning we got that number and it was quite weak. As such, we continue to expect the June Pending Home Sales number to be weak sequentially and likely to be accompanied by a downward revision to the May number. We illustrate the growing divergence between the two series in the first chart below.


Here's a summary look at the data: 

* Composite Index:  -0.2% sequentially and lower for a 3rd straight week 


* Purchase Apps:  Down -0.7% sequentially and also down for a 3rd straight week.   Ends June -15.9% YoY and +3.0% on a QoQ basis


* Refi:  Up +0.10% WoW with the YoY improving to -48.5% from -56.5% prior. 


* 30Y Rates:  The rate on the 30Y FRM contract returned to the lowest levels YTD at 4.28%, down from 4.33% the prior week.  Rates have now been negative on a YoY basis for 2 consecutive weeks and, on a monthly average basis, June marked the lowest cost of conventional home financing since April of last year.   


















About MBA Mortgage Applications:

The Mortgage Bankers’ Association’s mortgage applications index covers more than 75% of mortgage applications originated through retail and consumer direct channels. It does not include loans delivered through wholesale broker and correspondent channels. The MBA mortgage purchase applications index is considered a leading indicator of single-family home sales and construction. Moreover, it is the only housing index that is released on a weekly basis. 



The MBA Purchase Apps index is released every Wednesday morning at 7 am EST.


Joshua Steiner, CFA


Christian B. Drake

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LEISURE LETTER (07/02/2014)



GTech Spa – said it would undertake a share repurchase programme to fulfil management stock incentive plans. The company’s board approved the buyback of up to 1,782,426 of its own shares. Based on Monday’s closing price of EUR17.85, GTech would pay about EUR$31.8 million (US$43.6 million) for approximately 1 percent of its share capital. 

Takeaway:  Approved a previously announced buyback 


CZR – announced that it would invest $223 million toward revamping the 2,256-room Quad Resort & Casino and rebrand it as the Linq Hotel & Casino. Reservations under the new name are on sale and the transition to the Linq brand is scheduled for completion on Oct. 30. The company is introducing the revamped property with $89-a-night room rates.

Takeaway: CZR trying to keep pace its competitors and room renovations and the resulting lift in ADR to $89/night.


LVS – COO John Caparella sold 22,840 shares on Friday, June 27th at an average price of $76.24 and now owns 15,680 shares.

Takeaway: Interesting sale as we don't often see insiders selling at this company.


PENN – Hollywood Gaming at Mahoning Valley Race Course took delivery Monday of the first of what will be a total of 850 video lottery terminals. Approximately 24 VLTs from manufacturer Multimedia Games arrived at the Austintown site. Additional shipments are scheduled over the next several weeks from leading manufacturers including Bally Technologies, Konami Gaming, Aristocrat and WMS.

Takeaway: Opening with 850 VLTs


BEE – announced it closed a $120.0 million limited recourse loan secured by the Four Seasons Washington, D.C. hotel. The loan bears interest at a floating rate of LIBOR plus 225 basis points and has a three-year initial term with two, one-year extension options available to the Company The financing replaces the $130.0 million financing previously encumbering the property. 

Takeaway: As expected and a slight savings on interest expense.


HOT – in Dubai, Starwood Hotels & Resorts has officially taken over a two-tower property which previously housed the 260-room Kempinski Grand and 200-room Ixir Hotel, reflagging the towers under the Le Meridien and Westin brands respectively as of July 1 under an agreement signed in April. 

Takeaway: Continuing to build the brand network via international conversions.


HST – announced it amended and extended its existing $1 billion revolver scheduled to mature in 2015 and its $500 million term loan scheduled to mature in 2017. The amended facility will extend the final maturity for both the revolver and term loan to 2019 (including extensions) and reduce pricing to reflect current market conditions.  At the new pricing level based on our present credit rating, the all-in pricing was reduced 30 basis points on the revolver and 32.5 basis points on the term loan.  Therefore, U.S. dollar denominated borrowings today would result in an initial all-in rate of 1.35% and 1.28%, respectively.  Today, approx. $220 million is outstanding under the revolver and $500 million under the term loan.

Takeaway: Reshaping the corporate credit facility...could a large acquisition be in the near future? 


CCL – Carnival offers agents triple point booking opportunity through July 31 (Travel Agent Central)

In celebration of the launch of Carnival Freedom's new schedule from Galveston, TX kicking off in February 2015, Carnival is offering travel agents a special triple point booking opportunity in its Travel Agent Rewards Program.  Beginning today through July 31, travel agents may earn 450 points (compared to the standard 150 points for new online bookings) through 2016 for all “Fun Ship” departures from Texas.

Takeaway:  Galveston has been a trouble spot for CCL for bookings and pricing in 2014.


NCLH – Norwegian Gem schedule tweaked to avoid strengthening storm Arthur (Seatrade Insider) 

Norwegian Gem is calling at Nassau on Tuesday instead of at Great Stirrup Cay as planned. Gem is due to depart at midnight and begin its return to New York City to stay ahead of the storm in more pleasant weather.  Arthur is expected to be a hurricane by Thursday.


Imported workers make up nearly 40% of workforce (Macau News)

According to the Human Resources Office (GRH), Macau’s number of imported workers (commonly known as blue-card holders) reached a record 159,299 at the end of May, 33,699 more than a year earlier.  Month-on-month, the number of non-resident workers rose by 3,091

Takeaway:  Labor issues will be in the spotlight as we get closer to the new Cotai openings.


Saipan Gaming Expansion – Imperial Pacific International Holdings Ltd, a Macau junket investor, disclosed via a HKSE filing it would distribute cash vouchers totaling US$10 million among all locally born adults in the U.S. Pacific territory of the Commonwealth of the Northern Mariana Islands if the company were to win a casino license.  Based on 2010 United States Census Bureau data, 53,833 people lived in Northern Mariana Islands and 74% (39,836) are estimated to be aged 15 or over. 

Takeaway: This distribution won't make locals "rich" as the distribution represents about $250/person over age 15. 


South Korean Gaming Dispute (Chosun Ilbo) Four Chinese tourists staged a protest at Jeju airport in May after a casino on the island refused to pay them baccarat winnings of KRW1.1 billion (US$1.09 million) because of suspicions that they cheated. The four individuals were customers at a casino hotel in the tourist resort of Seogwipo and racked up the ‘winnings’ in little more than two hours of play at the baccarat tables.  But management at the casino – a venue not named by the police – suspected the Chinese tourists had colluded with casino staff, possibly by asking a dealer to use sleight of hand to swap cards coming out of the card shoe with ones hidden on the dealer’s person. The incident, which allegedly occurred in May but has only just been reported, is now the subject of litigation between the players and the casino.

Takeaway: Interesting controversy as well as timing given Gentings recent announcement to delay the Jeju groundbreaking. 


South Korea Replacing Macau – (Xinhua) Chinese tourists no long need to bring a large amount of US dollars when traveling in South Korea, as they can choose to use China UnionPay, or even renminbi in cash in some stores. China is the first source of tourists for South Korea.  From January to May this year, Chinese tourists exceeded 2 million. South Korean banks have also witnessed a large amount of renminbi deposits since the second half of last year, with the total volume reaching US$11.3 billion at the end of May. South Korea expressed its intent in April to build up renminbi offshore trading markets. 

Takeaway: Some Chinese VIP gamblers could be going to South Korea rather than Macau...


Massachusetts Gaming Support(WBUR) a new WBUR poll indicated 56% of respondents approve of locating casinos in Massachusetts, while 38% disapprove and 6% don’t know, or refused to answer.  

Takeaway:  So far, the pro-casino side has the lead.


Hedgeye remains negative on consumer spending and believes in more inflation.  Following  a great call on rising housing prices, the Hedgeye

Macro/Financials team is turning decidedly less positive. 

Takeaway:  We’ve found housing prices to be the single most significant factor in driving gaming revenues over the past 20 years in virtually all gaming markets across the US.


Client Talking Points


$1.71 vs USD this morning (signaling immediate-term TRADE overbought within a bullish TREND) after another excellent economic data point (UK Construction PMI 62.6 for June vs 60.0 in May), which is unlike the U.S. data (which isn’t showing much as the USD declined in June). #StrongPound is winning.  


UST 10YR yield of 2.55% didn’t particularly care for the SPX short squeeze (in fact, day over day, it hasn’t moved) = in line with the sequential slowing in both the June PMI and another bad U.S. Home Price report (June Core Logic Home Prices down to +7.7%year-over-yeary vs +10% in April); buy bonds.


We sent out the cover signal on June 12th and the sell signal again yesterday at 1208; that’s my line, for now (it’s the all-time closing high from March 4th); from a style factor perspective, much prefer being long inflation and slow-growth #YieldChasing to US domestic consumption growth.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

Hologic is emerging from an extremely tough period which has left investors wary of further missteps. In our view, Hologic and its new management are set to show solid growth over the next several years. We have built two survey tools to track and forecast the two critical elements that will drive this acceleration.  The first survey tool measures 3-D Mammography placements every month.  Recently we have detected acceleration in month over month placements.  When Hologic finally receives a reimbursement code from Medicare, placements will accelerate further, perhaps even sooner.  With our survey, we'll see it real time. In addition to our mammography survey. We've been running a monthly survey of OB/GYNs asking them questions to help us forecast the rest of Hologic's businesses, some of which have been faced with significant headwinds. Based on our survey, we think those headwinds are fading. If the Affordable Care Act actually manages to reduce the number of uninsured, Hologic is one of the best positioned companies.


Construction activity remains cyclically depressed, but has likely begun the long process of recovery.  A large multi-year rebound in construction should provide a tailwind to OC shares that the market appears to be underestimating.  Both residential and nonresidential construction in the U.S. would need to roughly double to reach post-war demographic norms.  As credit returns to the market and government funded construction begins to rebound, construction markets should make steady gains in coming years, quarterly weather aside, supporting OC’s revenue and capacity utilization.


Legg Mason reported its month ending asset-under-management for April at the beginning of the week with a very positive result in its fixed income segment. The firm cited “significant” bond inflows for the month which we calculated to be over $2.3 billion. To contextualize this inflow amount we note that the entire U.S. mutual fund industry had total bond fund inflows of just $8.4 billion in April according to the Investment Company Institute, which provides an indication of the strong win rate for Legg alone last month. We also point out on a forward looking basis that the emerging trends in the mutual fund marketplace are starting to favor fixed income which should translate into accelerating positive trends at leading bond fund managers. Fixed income inflow is outpacing equities thus far in the second quarter of 2014 for the first time in 9 months which reflects the emerging defensive nature of global markets which is a good environment for leading fixed income houses including Legg Mason.

Three for the Road


Update to maternity model pointing to acceleration.  $MD $HCA



"Concentration is the secret of strengths in politics, in war, in trade, in short in all management of human affairs."

- Ralph Waldo Emerson


19, the age of Australia’s Nick Kyrgios who was victorious against Rafael Nadal yesterday in the fourth round of Wimbledon. Kyrgios became the first player in 22 years ranked outside the top 100 to beat the number one player in the world.

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