Part II: Opportunity Industry Description

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

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: 2121-01) 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 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 (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 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 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.

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 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 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).”

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% (Altria Stock Report & 10k)	(1 – 0.79) * 0.148 = 3.1% (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% (Altria 10k)	123,000,000 / 8,419,000,000 = 1.5% (Reynolds American 10k)
Establishment of Brand Names ((marketing cost/revenues)	(2,673,000,000 / 16,824,000,000) = 15.9% (Altria 10)	(1,413,000,000 / 8,419,000,000) / = 16.8% (Reynolds American 10k)

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. Average Distinctive Competency Scores 

Average

3.83

2.83

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).

Bibliography

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Altria. Web. 19 Nov. 2010. .

Altria Group, Incorporated - Company Report US. Rep. Jersey City: IbisWorld, 2010. Print.

Koppel, Nathan. “Tobacco Lawsuits Puff Along in Florida – WSJ.com.” Business News & Financial News – The Wall Street Journal – WSJ.com. 07 Oct. 2010. Web. 17 Nov. 2010. http://online.wsj.com/article/SB10001424052748704689804575535991535706632.html

Kopylovsky, Dmitry. "IBISWorld Industry Report 31222: Cigarette & Tobacco Product Manufacturing in the US." Www.ibisworld.com. IBISWorld, Sept. 2010. Web. 17 Nov. 2010.

Reynolds American Inc. - Home. Web. 19 Nov. 2010. .

Reynolds American, Incorporated - Company Report US. Rep. Jersey City: IbisWorld, 2010. Print.

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Reynolds American, Inc. Form 10-K. United States Securities and Exchange Commission, 19 Feb. 2010. Web. 25 Nov. 2010. .

Stock Report: Altria Group Inc. Rep. New York: Standard & Poor's, 2010. Standard & Poor's. Web. 17 Nov. 2010.

Schreibfeder, Jon. "Why Is Inventory Turnover Important?" Effective Inventory Management. Web. 18 Nov. 2010. .

Young, Greg. Industry Analysis. North Carolina State University, 11 Oct. 2010. Web. 1 Dec. 2010. .

Young, Greg. Review for Team Research Paper. North Carolina State University, 17 Nov. 2010. Web. 1 Dec. 2010. .

Porter, Michael. "Porter's Five Forces." http://www.quickmba.com/strategy/porter.shtml. QuickMBA.com, 2010. Web. 29 Nov 2010. <http://www.quickmba.com/strategy/porter.shtml>.