Ump on a Blog

This week the U.S. Food and Drug Administration was granted permission to begin regulating the tobacco industry, which is step #2 in what will probably be a slow, but ultimately inevitable, decline of Big Tobacco in the United States. Look for nearly-immediate regulations concerning labeling, ingredients, quantities of addictive substances that are permitted, and most likely even restrictions on imported product as well. It has been more than 50 years in the making, but the cigarette is about to become an unprofitable venture for American sales. I’ll explain that in a second.

To get an understanding of exactly how big Big Tobacco is, and how much money they make (and how they make it), read “Barbarians at the Gate: The Fall of RJR Nabisco” by Bryan Burrough and John Helyar. The book is about the leveraged buyout of the RJR Nabisco corporation, which for those non-MBA folks can be a tremendous bore. But in the process of going through the details the book outlines the mountains of cash that tobacco companies rake in on a daily basis, and what it goes towards.

To give you an idea, a pack of cigarettes goes out the factory door for a cost of production lower than a dime. Federal, state and local taxes make up the bulk of the price you pay at the 7-11, but when all is said and done that ten-cent pack of cigarettes results in profits of at least $1.00 – $1.50 for the tobacco company.

45 million smokers. Average consumption of one pack a day. Grab your handy-dandy calculator and do the math on that, and you’ll have a good idea of what kind of loot we are talking about here. A good portion of that goes, very literally, straight into the pockets of sympathetic politicians who work to tear the guts out of any substantial anti-smoking legislation. Until now.

Now, unlike before, there will be costs associated with compliance with new FDA rules. Inspections; audits; mandatory reporting; monitoring of ingredient quantities compliance; ingredient purity compliance; and on, and on, and on.

Big Tobacco will most likely see its cost of administration skyrocket, which will translate into higher per-unit costs that will be passed on to the consumer as higher prices. Higher prices means lower demand, and lower sales. Ultimately some companies with small domestic market share will opt to simply bypass the American market altogether.

But is this “the end?” Not hardly. While the United States is a big market, American cigarettes are some of the most coveted brands in the rest of the world, and cigarette companies are not below profiting directly from the black marketeers in places like South America, Southeast Asia, and former Soviet Bloc countries. They skip the retail channel, move the cigarettes in via shipping containers using foreign subsidiary corporations (with a wink, a nod, and a quick $100 to the local authorities to look the other way), and sell direct to the streets at black market rates — and avoiding all of that pesky import duty and government regulation and taxes in the process. Foreign mafia are more than happy to cooperate, acting as distribution channel and raking in a nice profit themselves while cutting out the middle-man from the process.

So while the legal market in the U.S. is Big Tobacco’s easiest source of cash, as that one dries up they will further exploit foreign markets and the money will keep flowing. Big Tobacco isn’t finished, it’s just re-tuning it’s business model. While there are still smokers to buy them, there will be tobacco companies to make them.

As the number of American smokers dwindles and the sales tax revenue starts declining with it, we will have to start imposing export duties to get the same “bang for the buck” as we do now with retail sales taxes. Other than that, it will be business as usual.