Chit Chat Stocks - The State of the ~NICOTINE~ Industry With Devin LaSarre

Starting point is 00:00:00 All right, options traders, listen up. I want to tell you a bit about public.com. But first, have you ever actually thought about all the fees you're paying to trade options? Aside from the regulatory fees, there are commissions and most platforms charge per contract fees too. That's what makes today's sponsor, public.com, so interesting. Public doesn't charge commissions or per contract fees. And in an industry first, they offer a rebate of up to 18 cents per option contract traded check it out if you trade a thousand options contracts on public you'll get up to 180 in rebates if you trade 10 000 contracts you could earn almost 2 000 bucks more importantly the rebate means you can maximize your profits and minimize your losses to recap no commissions

Starting point is 00:00:43 no per contract fees and up to 18 cents on every contract traded see why nerd wallet recently awarded public five stars for options trading and start earning up to 18 cents per contract traded only at public.com. This is paid for by public investing. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description, US members only. Welcome to Chit Chat Stocks. On this show, hosts Ryan Henderson and Brett Schaefer analyze businesses and riff on the world of investing. As a quick reminder, Chitchat Stocks is a CCM Media Group podcast. Anything discussed on Chitchat Stocks by Ryan, Brett, or any other podcast guest is not formal advice or recommendation. Now, please enjoy this

Starting point is 00:01:32 episode. All right. Welcome in, everyone. This is another Wednesday edition of Chitchat Stocks. Ryan is gone again. This is the same week we have recorded the interview with Todd and Jim. He's over at a, I don't know what it's even called, but he's meeting with our good friends, FinChat, where he works, having a good old time over there. But today we have on a perfect guest to discuss the, well, we were joking about it before. Everyone calls it the tobacco industry, but as we'll get into, we may want to call it going forward, the nicotine industry, because that's a little bit of a better overview of where the future of the sector is going. It is Devin Lassar, writer of the Invariant Substack and Newsletter, past guest.

Starting point is 00:02:26 We discussed, I believe, the state of the tobacco industry and British American tobacco. Actually, one of our top episodes, I think it was in 2022, so two years ago now. And I think maybe we've had another episode with you, but at this point, it's been a few years, So it's honestly hard to remember all the ones we've done. But welcome back to the show. And why don't you, before we get started, talk about the Invariant Substack, what you're doing over there and how much you're covering. It's not just nicotine stocks, but a lot of focus on that sector.

Starting point is 00:03:01 Well, yeah, Brett, thanks for having me. Happy to be back on. I think this is the third time that I'm on the podcast joining you. Yeah, over at invariant.substack.com. writing on a variety of things related to finance, history, investing philosophy, spend a lot of time covering the nicotine industry, as well as a number of other companies I find interesting or out of favor or all the above. Yeah. And you write a lot, as you mentioned, about nicotine. One of your most popular pieces

Starting point is 00:03:39 and one that I read in preparation for the show was back in 2022 called the new era of nicotine. And in that you said, I think this is where a lot of people maybe misunderstand the sector is that your quote is nicotine isn't going away. It's merely evolving. And that's how you closed your article here. I guess for anyone that's new, how has nicotine evolved in the last few years? And why is it a growth story? it's changed in so many ways and you know in a totally different perspective nothing has changed at all um the industry is experiencing similar trends seen in previous decades such as continued declines of certain legacy products namely cigarettes same time we see this growth story

Starting point is 00:04:33 that is next-gen or reduced-risk products. There's a lot of push-pull between all of that going on, between major manufacturers, small startups, regulators, across different geographies. It certainly makes for a colorful story with a lot of uncertainty around it and certainly remains a very contentious industry for most. yeah i agree and there are a ton of moving parts as you mentioned there's the legacy business the legacy operations that as is you know famously been in terminal decline from a volume perspective

Starting point is 00:05:14 for multiple decades as people who follow the sector know there's been a lot of pricing power there but then over the last decade there's been the nicotine pouches the vaping the heat not burn products. That's been a story of the last few years. And it seems like that story has kind of been a secular growth story, been fairly consistent. But I wanted to ask before we get into any details here, you followed the sector closely for at least the last few years, if not longer. What has surprised you since you've written that article back in 2022? Yeah. So, I mean, I've been following the industry since 2010, but only I've been writing about it publicly for a couple of years.

Starting point is 00:05:55 I'd say two things that surprised me over the period have been the Swedish match deal actually closing and getting done. I was fairly public about my apprehension in assuming it would get done initially. I had my doubts. And along with that, following the acquisition, I've been very surprised about not only the sustained growth, but the accelerated growth of Zin.

Starting point is 00:06:29 I think that's been remarkable. And the growth rates we're talking about right now, I'm not sure if anybody was penciling them in ahead of time. It's kind of wild. Yeah. I mean, I remember the deal. I was very optimistic about the nicotine pouch growth, but not, I don't think, yeah,

Starting point is 00:06:50 you mentioned and nobody was that optimistic it's been such a surprise i think do you think it's that growth would have occurred if they were the standalone company because i think one of the benefits was they hopped on the philip morris international distribution or am i totally off there because they didn't really have a presence in the united states anymore Right. I mean, I think that PMI has some serious ability in terms of operational skill, in terms of executing, understanding the growth rate and what needs to be done to be able to increase capacity, manage distribution, continue to grow into new markets. It's hard to say to what extent that would have happened if Swedish Match remained a standalone, but it's hard to argue that Swedish Match's performance hasn't been rather awing under the hood of PMI. And along with that, throughout the rest of the world, they really haven't increased distribution all that much yet. So there's still a large growth opportunity, I think, in most parts of the rest of the world outside of Scandinavia.

Starting point is 00:08:10 Right. And for any listener that doesn't know, Phil Morris International, as the name implies, sells a lot of tobacco products, cigarettes in international markets. So I think what you're referencing here, and correct me if I'm wrong, is that, for example, Philip Morris International has a ton of distribution points in, say, Egypt, which is probably a very hard market to crack, especially for a Western company. and now that they have these nicotine pouch brands or excuse me the one brand or maybe i guess a couple others they can go into egypt much more easily with these risk-reduced products and that can give them a potential advantage versus any other upstart yeah i mean they definitely have a head head start in that regard i mean distribution it's kind of a central pillar in terms of the main advantages for the major manufacturers right Right. And really, it's just BAT and PMI that have those massive, truly massive distribution footprints on a global level.

Starting point is 00:09:12 And along with that, I mean, really, you have the distribution. So it comes down to production capacity, then being able to raise consumer awareness of the product and leveraging your distribution, get it to where it needs to be that you can spur trial and adoption. but yeah throughout much of the world that hasn't really even begun for the nicotine pouch category okay and when you wrote in that article the new era of nicotine plus another follow-up one which i forget the exact name but you can you can say it uh so let's go check it out you talk about how there is a misconception just given the cigarette volume declines that this industry is you know left for dead uh a lot of people say you know it might be dead in 10 years in certain markets or 20 years and when you actually look at the numbers and you you know don't just look at cigarettes but

Starting point is 00:10:08 look at the entire nicotine category we're actually seeing volume growth and maybe you could toss out some numbers around that and why you think that is happening right um yeah i mean i don't have all the numbers right in front of me right now i'll try to go off my head just in speak in general terms here, speaking about the evolution we're witnessing. But it comes down to a couple things. One,

Starting point is 00:10:37 you have the legacy story of cigarettes, which I think people are most aware of. You have a secular decline. Under the hood there, you have a couple things occurring that aren't as well-known

Starting point is 00:10:52 and I think are misunderstood. You have the Percentage of prevalence usage amongst adult cohorts decreasing. But part of that is actually the denominator effect of population growth. You have less people reaching adult age that are initiating smoking. But you still have a pretty sizable number that eventually start using nicotine in one form or another. When you look at volumes, you've seen volumes of cigarettes decrease at elevated rates in the last couple of years. And we can point to a couple of things.

Starting point is 00:11:37 We can point to inflation pressures leading to excess price take above historical norm, along with the rise of next-gen products. however most people focus on volumes they don't look at the you know big other variables such as the cost to produce the goods and what are you actually selling them for right and at the end of the day even with these elevated pressures the manufacturers are in a pretty good position in terms of look at the margin profiles of these products you look at the total size of operating income that these products are producing and yeah the story that cigarettes are gone in 10 years i think it's a little bit far-fetched right right yeah i mean especially when you look on a global basis you know some of these markets like what is the top i believe it's indonesia yeah oh yeah

Starting point is 00:12:37 story right right for even legacy right yeah i mean you might not be selling for 20 a pack like in Australia, but there is still a lot of demand to be had over multiple decades. And I think one note you had in the most recent one, I believe, is that it makes sense if you raise the price on something by 10x, even given how addictive cigarettes are, there's going to be some decrease in demand. And if there's no other options out there, well, people aren't going to go to it. But now that we have these new age products that are one, safer, they're not as culturally shamed right especially in the united states and north america and they cost less it's understandable how they're being explosive of i think you called it latent demand for for nicotine

Starting point is 00:13:26 that yeah maybe you can go into the history of how it's you know ever since i guess the clone hill times there's been just an explosion of demand for nicotine around the world oh if i go through the whole history we're going to be here for hours maybe uh i like the maybe one anecdote i know you have a lot of historical examples around sure i mean i mean you you can look way back of when it first truly started to spread across the world and you know you have monarchs and dictators looking at this product and seeing you know it wasn't necessarily the concerns of health harms but seeing that this the tobacco was starting to have more power than them over their people. And so they go, hey, we catch you smoking. We're going to cut off a finger, a hand, or maybe

Starting point is 00:14:11 we'll take all your possessions and jail you. And it didn't stop anyone, right? It continued to spread. And eventually they kind of conceded to its presence and go, hey, we can't really stop it. So we may as well tax it, recognize a huge amount of revenue, use that to finance whatever endeavors we need to finance. And so the story goes. More recently, say in the last 70 years, we've become very aware of the health harms of these products. So when you look at the evolution of regulation, it's all centered around the societal health effects of these products, trying to curb and reduce usage, trying to educate on the harms. So you see all kinds of things occurring in terms of Warning labels, rules about where people can smoke, look at excise taxes used to

Starting point is 00:15:06 kind of decrease affordability to reduce prevalence, et cetera. Flavors, right? Famously, recently, the menthol ban in California, correct? Yeah, sure. Yeah. All of these things, it's all largely focused around the health impacts of the product. And so when you look at affordability, something I posited recently, I think this was in the piece, you referenced it, the nicotine arc, which was that if you have these next-gen products where science suggests that they're remarkably lower risk than cigarettes, where if you look at a continuum of risk, you look at the total risk profile of the product, cigarettes being a 100, you can go way, way down, and you're talking less than 10%, less than even 5% of the relative harm.

Starting point is 00:16:05 And so if you can reduce that harm profile, and you think about the product affordability from a cost to one's own health, there there should be a significant amount of demand that that is to be recognized for these new product candidates and in that same vein when you talk about pricing there there's maybe even a potential that people are willing to to pay more for products that are far less harmful to their health down the line and along with that you have an advantage for for the governments looking to regulate these products, the manufacturers, and the consumers, which all benefit by consumers being relatively healthier, living longer, getting to purchase for longer, etc. Everybody kind of wins in that very generalized perspective.

Starting point is 00:16:59 Right. Makes sense. Now, I had a couple of follow-ups on regulation. Maybe we can hit them now. You talk in some of your write-ups here about what regulation looks like versus what it should look like, or maybe, I guess that's just your opinion, maybe, you know, listeners should be aware of that. But what are the main differences you see today, maybe in the United States, we can be specific there, versus like how some of these new products, nicotine pouches, vaping are regulated, versus how you think they should be to align, as you mentioned, customers, companies, and government outcomes. Sure. Yeah. Well, you know, I'm not a scientist, doctor, or politician, but yeah, you know, looking at how this has played out and

Starting point is 00:17:51 looking at the positions, some very public positions taken, it's kind of bizarre, especially looking at some of the words that have come out of the FDA and then trying to line that up to their actions. And it doesn't make a lot of sense in that you can look at, you know, Brian King, director of the FDA's CTP, saying that they know that vapes as a category are markedly reduced risk relative to cigarettes. And they acknowledge that. They also, you know, right on the FDA website, they recognize that it's the combustion aspect of cigarettes, not the nicotine that that is the origin of the majority of the harm and yet you you know look at our country and i think most people or a majority of people aren't aware of those kind of basic

Starting point is 00:18:50 facts and the fda has stated in the past that they want to educate the public on these facts And you can look over, what, it was 2017, 2018, they said they're going to make a really big push in terms of educating on those specific aspects. I missed that, yeah, I didn't see it. And trying to educate and incentivize adult smokers to switch to reduced-risk products. When you look at the environment today, you've got to kind of question what they've been prioritizing for the past few years. See, you asked in terms of how I think things should be regulated. I don't have all the answers, and it's terribly complex. But at a very basic, a very minimum, I think there should be an expectation

Starting point is 00:19:41 that adults are armed with the correct comprehensive information so that they can make choices for themselves. Just like somebody can go out, they can eat 15 cheeseburgers a day or drink nothing but soda or never work out. You know, it's their choice, their prerogative. We can make those decisions for ourselves. So same is true for alcohol, same is true for tobacco or nicotine. Cannabis largely in many states today.

Starting point is 00:20:11 Sure, exactly. And I think having the full and accurate information is critical to allowing people to make those informed decisions for themselves. At the same time, something that's rather odd to me that almost isn't even part of the discussion is putting greater emphasis and resources towards age verification at the point of sale. You know, I think a big talking point for opponents of nicotine and tobacco are concerns around underage usage, and nobody should be for underage usage.

Starting point is 00:20:56 It's clearly an adult product category. But if you're truly concerned about it, why wouldn't you want to funnel resources towards really making sure at point of sale, ages are being verified, and for anybody that's not in compliance, there are penalties that are strict enough and severe enough that really disincentivize breaking those rules. Right, similar to alcohol. And what's interesting is you would think

Starting point is 00:21:29 you'd want to incentivize some of these larger companies or maybe not even the larger ones, companies with these reduced risk products that have fairly good evidence that these products are way less harmful, as you mentioned, compared to the legacy cigarettes. You'd want to incentivize them to probably do some advertising, right?

Starting point is 00:21:47 but i guess there there's such a restriction around that that it seems like no one can get it's really hard to push out into the world any sort of updates on how these products work what the actual health outcomes are and how nicotine works with the body yeah and i i think part of it is how do you how do you balance the total effect on all of society's health how do you educate and get the information to adult consumers without also potentially making these products more appealing to underage people, right? And so how do you balance that best? And that's a tough question. At the same time, there's other considerations, which I think are maybe more nuanced, but you can look at it and think about, well, maybe that information,

Starting point is 00:22:40 that type of advertising should be out there, simply for the fact that the majority of the harm incurred is to adults that have been smoking for a long while, right? And so those are the people that would benefit the very most from switching, right, to reduce risk products. At the same time, if you look at the risk profiles of these next-gen products, you know, you can look at youth or underaged use and say, you know, it's not great that there is some degree of underage use, but it's certainly better than if those same users were using cigarettes, right? On just a total harm basis. And, you know, those are true things to consider. And along with that, I think people are rightly concerned with underage use. And I think it's something that should be focused

Starting point is 00:23:39 on again focus on age verification um but i think some of the narratives such as you know these new products are predicting a whole new generation those certainly are a bit sensationalist when you look at the numbers if you look at you know data of certain middle school and high school cohorts. The number that have tried a certain product over the last year versus any time during their whole life versus within the last month versus daily. If you were seeing a true sweeping widespread addiction, all of those numbers in terms of more frequent use would be going up. And they're actually going the opposite direction. So, yeah, I think it's important to look at the data.

Starting point is 00:24:36 I would look like nothing more than for regulation to be based on both the science and the actual numbers. Okay, let's go to the specific growth of some of these risk-reduced products. I'm going to focus not on vaping today, as I think that is a bit more of a crapshoot. It's kind of hard to see. I think what I'm really interested in, I think listeners will be as well, is the global expansion that seems to be potentially underway of either nicotine pouches, which for reference were popular in the Nordics and North America, and then heat not burn products, specifically Icos and other ones that, and correct me if I'm wrong here, they're popular in Europe or Western Europe, Eastern Europe, and Japan. Now, I guess we can start with Heat Not Burn. Why or why not can these products go global? And we're about to get it launched in the United States. Why would it or would it not be successful in other markets? That's a good question. I think that there is significant potential for heat not burn as a product category. Obviously, ICOS is leading the pack. I think it is far and above the best version of anything on the market. And I don't think it's all that close, to be honest.

Starting point is 00:26:06 As to why it would succeed in any market, we can define that in different ways, but it requires two real sources to lead to that success. One, consumers wanting the product and regulators allowing it, right? Those are pretty essential. In terms of why consumers would want it, we can look at what this product is, which is, in fact, tobacco. It's composite tobacco sticks, heated, not burnt, therefore total risk profile substantially lower than cigarettes, but arguably mimics the physical act, the ritual of smoking a cigarette best across the three next-gen product categories. So I think you can look at it and identify some clear appeal in that regard. And it's certainly evident, as you mentioned, we've seen it in Japan, we've seen it in parts of Western Europe where this product is extremely popular and it's continuing to be more popular seemingly by the quarter. and what about the regulatory stuff like what's keeping i know there's always lobbying

Starting point is 00:27:26 in uh nicotine but what's keeping governments from incentivizing this or what needs to happen to get you know get them out to the market so there's a couple considerations and it is one understanding the actual risk profile of the product so obviously regulatory bodies whether whether it's within the same body you're partnering with with health bodies substantiating the health claims of these products and understanding the actual risk profile and it coming down to the idea of countries embracing thr tobacco harm reduction which is well you can't regulate nicotine out of existence if you try to do that it only leads to bad things like large black markets that you really don't have visibility into.

Starting point is 00:28:15 You're no longer collecting excise tax proceeds that can go to health costs and, you know, enforcement and other things, et cetera. And, you know, instead, we can look at the reduced-risk products, understand the reduced-risk profiles, incentivize adults to switch to them by taxing them at lower rates and therefore having the retail price be more attractive. And then maybe potentially we also allow the packaging to have a reduced health or reduced risk claim to let people know, hey, if you were to switch one-to-one, A to B, it would be net positive for your health. I think we can look at a number of countries

Starting point is 00:29:04 that have really embraced such ideas, especially something like Sweden, where they have a high prevalence historically of oral usage, really the birthplace of snus and then nicotine pouches, very high usage prevalence of those products, very low smoking rate. And when you look at it, the total harm experienced by the country from tobacco

Starting point is 00:29:33 is substantially lower than the rest of the West. So that's kind of a blueprint for what can be done. Regulators, if health bodies are serious about reducing the total health costs incurred, tobacco harm reduction seems like a fairly straightforward route to go, simply because what other route can you do? Some people I know are proponents of things like generational smoking bans. But again, long-term, do you think that's really going to work? Think 30 years down the road, right?

Starting point is 00:30:08 You have two people, maybe in their 50s. One person is one year older than the other, can buy legally. The other can't. Are they both going to be carded, both not going to be carded? One not going to buy for the other one? And does that not lead to a massive black market as well? So you can see countries like New Zealand, where they're backpedaling on such policies. The UK as well now.

Starting point is 00:30:37 India too, right? Or is that not? Is that a different thing? So India's been very unreceptive to next-gen products. So I believe it was 2019, they banned all vaping products. And you can look at the vaping industry in India and massive black market. And along with that, you know, you can look in the last half decade, there were a couple of years when they had a massive step up in the excise taxes on cigarettes. And at the same time, they didn't funnel appropriate resources to checking volumes for illicit counterfeit volumes.

Starting point is 00:31:20 And so they had a booming black market there. And so it's, all right, now you have – you raised excise tax rates, but you're collecting less, and now you have to throw resources towards dealing with this black market. And, yeah, they're taking some initiative now to undo kind of some of the damage that they've done. but it's it's kind of a very good story showing what happens when you push some of these levers or pull on them a little bit too hard um what can go wrong sound the alarms we have a new sponsor alert that's firmreturns.com it's a stock research blog our friend runs that and it has covers companies from all around the globe but it leans really more towards the uk as that's home market and it gives him easier access to management and he provides ongoing updates on

Starting point is 00:32:15 the companies that he's invested in as well as an archive of longer form write-ups that you can access all for free there is a paid tier but there is tons of free content out there and these reports are very thorough to give you an example of just how thorough some of these are at one point he was digging into a company's account and for one company he wrote up recently he actually managed to find a material misstatement that had been missed by the auditors and management reached out and confirmed the error to him and these are companies of all different sizes from all different sectors and all different markets around the globe both the focus on his home market in the united kingdom if you want to check this out firmreturns.com like i said tons of free content

Starting point is 00:32:58 on the website if you're interested in one of the paid plans you can go to firmreturns.com chitchat that's firmreturns.com slash chitchat and it'll get you 20 off right now i want to talk nicotine pouches too again as i mentioned popular north america and the nordic countries let's assume for a minute that the regulatory regulatory hurdles are passed and in almost every market around the world you know let's say excluding china which you know has their own their own game um a country or excuse me a manufacturer a brand can offer the same sort of you know they have the same distribution as the united states same sort of brand marketing powers all that good stuff let's say they get past the regulatory what prevents nicotine pouches

Starting point is 00:33:51 from becoming popular around the globe as cigarettes did? It's popular in Latin America, Africa, Europe, Asia, North America. What's preventing that to happen from nicotine pouches and maybe these heat not burn ones as well? Yeah. So I'm not sure if you recall,

Starting point is 00:34:11 I think it was the first time you had me on the podcast maybe two years ago. I think one of the final questions was you and Ryan asking me out of the three next-gen categories, what one I was most interested in and thought had the most promise. Yes, I remember. I had explained, you know,

Starting point is 00:34:29 I think they each have some really interesting qualities that can lead them to succeed in different geographies, different ways for different manufacturers. But as a whole, I thought that the nicotine pouch space had some particularly interesting qualities. And when you think about the product, there are a lot of things in its favor. It's lightweight, small, discreet. People can't tell you're using it.

Starting point is 00:35:04 It has the lowest risk profile out of all the product categories. It doesn't stain the teeth. You don't need to spit. There's no smell. You can use it any time of day. And it's also extremely consistent, right? And there's nothing to fuss about. You don't need a lighter.

Starting point is 00:35:23 You don't need a charger, right? You can use it in any temperature environment, any wind environment. There's an endless, seemingly endless list. Also, it's fairly straightforward to manufacture and distribute. And so because of that, right now we're seeing nicotine pouches grow faster, far faster than the other two categories. And that recent differential, the step change in growth rates, has been rather interesting.

Starting point is 00:35:59 For a long time, if you looked at any of the industry reports, almost everybody had vaping was going to be the end-all, be-all. Its growth rate was going to continue to accelerate and it would be larger than heat not burn and oral. And despite the proliferation of all kinds of illicit brands from foreign manufacturers distributed in the U.S. across parts of Western Europe, we've seen a degree of slowdown in vaping as a whole, especially seeing a slowdown in things like open tank and then pod-based. especially in pot-based, but the nicotine pouch category is accelerated. I don't know where it ends up exactly, but the current growth rate could be sustained for years to come. Yeah, and for any more information on that, I'd recommend your interview on the Yet Another Value podcast

Starting point is 00:37:11 talking heap group which is a specific distributor um they've also or excuse me it's a e-commerce player in the nicotine pouch space uh i guess to go to that podcast also your write-up on that for any information on maybe a interesting way to play that growth but i want to switch away from risk-reduced products and talk about something that if you're looking more on an investment perspective i'd maybe you have a different opinion but i'd say the main reason why you know altria group british american tobacco i guess too as well why the pe the earnings ratio is down in the dumps so much is because of the accelerated volume declines in the united states for cigarettes and i i want to hear your opinion on why you think the accelerated volume declines

Starting point is 00:38:05 are happening? Is this the new normal? Why do you think it's happening? Obviously, the future is uncertain, but where could it go from here? Sure. Well, we touched on this a bit already in that you have the price take for manufacturers along with next-gen products taking total industry share total volume share leading to accelerated volume declines i think that's certainly the most straightforward explanation that makes sense it's hard to push back against i i don't know that that's actually the main source of why these companies have seen their multiples compress so much in that if you look at the multiple compression, it started to occur kind of well before the past couple of years in terms of the elevated volume declines.

Starting point is 00:39:11 And you can look at a couple of major moves in terms of capital allocation. You can look at Altria buying a 35% stake in Joule. You can look at BAT buying Reynolds, prices paid, timing of You can also look at the FDA statements in 2017 regarding their strategic overhaul, potentially reworking how they're looking at next-gen products, which brought serious doubts about the longevity of legacy products and kind of the potential trajectories that those could face in terms of volume declines. i think that the elevated volumes they've certainly weighed on on performance certainly if if you had limited ngps then legacy volumes would likely be much more than they have nonetheless i think that when you dig into the actual numbers there's a pretty massive disparity between sentiment centered around elevated volume declines and the actual operational performance

Starting point is 00:40:22 in terms of what they're actually generating, in terms of cash from operations, and in terms of how that's ending up as free cash flow and then being distributable to shareholders. And certainly sentiment is deeply negative as evidenced by almost, you know, every multiple of every single one of these companies. None of them are terribly high, quite the opposite in terms of their multiples. And I do think there's a large piece of it just strictly focused on volumes.

Starting point is 00:41:04 But, you know, I think I've made it fairly clear in my writing that To focus strictly on volumes is rather pointless, just like it is rather pointless to focus on any one metric for any one company, right? You have the cost it takes to produce those volumes and the price you can sell those volumes for. And you can bring into question the future demand arc in terms of how volume, decomposition, you know, estimates for the decline rate might change year to year, decade to decade, whatever. But I think there are quite a few scenarios in which the elevated declines we've witnessed where the industry is declining, you know, call it 8%, 9%. Maybe that moderates. I'm not saying it gets back to the, say, 4% range and you go back throughout longer periods of history, but maybe 6%, 7%. It can come down several points, which, again, when you still look at the inelasticity coefficient pricing and the ability to take price, manufacturers likely now lapping some of the inflationary pressures they saw on things like tobacco prices and certain other inputs.

Starting point is 00:42:27 there's pretty considerable runway ahead to continue to take price and grow revenue net of excise tax per pack per stick pretty substantially and along with that continue to widen operating margins at the same time

Starting point is 00:42:46 and what does international look like any standouts on either volume declines that have changed or a market that is holding up and maybe any companies that are exposed or could benefit or will be hurt from that? Yeah, I mean, I try not to focus too specifically on any one market, though I spend a lot of time looking at the US in that that is the largest, most lucrative market.

Starting point is 00:43:17 So it makes sense to put some effort into understanding that. I think what's interesting is when you look at the total value chain, you look at total industry volumes, you look at cigarettes. On a global level, the decline rate isn't anything like the headlines are showing for the U.S., right? You're still seeing low single-digit volume decline rates on a global level. Along with that, when you look at other legacy products, you look at roll your own, make your own, pipe tobacco, legacy oral, cigars, bundle all that together. Then on top of that, you throw on vaping, heated tobacco, and modern oral. You're getting to an industry where volumes are essentially stable. And then when you factor in the lack of transparency to the growing illicit markets for cigarettes, for illicit disposables in vaping and all that,

Starting point is 00:44:16 You can see that the total consumption rate for nicotine in the world is set to grow. And although the total growth rate, some would argue, isn't all that meaningful right now, and I would agree, like total volumes, again, you can't just focus on volumes. You can think out 10, 20, 30 years in the future. And if you have all these reduced-risk products that have substantially reduced risk profiles, if people are going to be consuming lots of nicotine for far longer, living longer, the total base of nicotine consumers in the world should be growing rather steadily far into the future. I think that's a pretty straightforward way to think about it. Earlier in the show, you heard us talk about the investing platform, public.com. That's where you can trade options with no commissions or per contract fees and you get a rebate of up to 18 cents per contract. NerdWallet recently gave public five out of five stars for

Starting point is 00:45:19 options trading. If you want to see why, go to public.com and start getting a rebate of up to 18 cents per contract traded. This is paid for by public investing. Options are not suitable for all investors and carry significant risk. Full disclosures are in the podcast description, US members only. Finchat.io is the complete stock research platform for fundamental investors. They have all the standard financial data on more than 100,000 stocks globally. And beyond that, they have company-specific segment and KPI data on more than 1,500 stocks. So to give some examples here, you want to see Netflix's average revenue per member over the last 10 years? They've got it. You like to track YouTube's advertising revenue? They've got that too. If you want to see

Starting point is 00:46:03 Celsius's revenue that comes from Costco, how much of their revenue comes from Costco. They also have that. So the breadth of FinChat segment and KPI data truly is one of a kind. I use FinChat every day to track and manage all my investments. I also use it to discover new investments. And if you want to get 15% off any paid plan, go to FinChat.io slash chitchat. that's finchat.io slash chitchat to get 15% off any paid plan. The link will also be in our show notes. Okay, that makes sense. And I have this question, I think, you've already answered it somewhat, where, you know, if you look at the big three tobacco companies, you look at some of the other ones as well, the performance stock wise, I guess we talked about a little bit already has

Starting point is 00:46:52 not been great over the last 10 years even total return including dividends and fairly poor i think maybe to reiterate why does that not continue over the next 10 i guess even if earnings grow multiples can continue falling but what you know what prevents them or excuse me you know, why will they grow their earnings over the next five to 10 years? Is it what you were saying, that volumes are going to be stable and they'll raise prices a little bit above inflation? What are your thoughts on kind of why the stocks have done so poorly and maybe if that can shift over the next decade?

Starting point is 00:47:35 Yeah, so there's certainly a mix of things. I think if you look at the last decade, no doubt the relative performance has been rather uninspiring. I think I can point to a couple of sources. Again, there's this massive divergence of the fundamentals versus the sentiment and price. So, of course, TSR, total shareholder return. Prices are kind of in the dumps, so it's going to look not too impressive. I think you have a couple of things occurring right now that has led to that.

Starting point is 00:48:17 You've had in major markets, such as the FDA, kind of announcing these overhauls that haven't quite materialized, but kind of spooked investors. You had the rise of NGPs, which initially NGPs, it was mostly from smaller manufacturers that initially really started to grow the market. And the major manufacturers kind of wrote it off initially, realized there was potential, and then invested aggressively to play catch up, whether it was internal development or acquisitions. And so you have this period where there's also this massive change in terms of what these companies look like in terms of the total capital intensity and the profile of the products, legacy products. There's like almost no capital intensity, right? You're reinvesting to just maintain these very massive machines that pump out billions of units and volumes down, price up, kicks off cash, return to shareholders. There's not a whole lot new going on there. And, you know, the main reason you're able to do that with the price take is you have this tremendous amount of brand loyalty that's been built up over decades, right?

Starting point is 00:49:39 Not a whole lot of innovation or new competition on that front. When you look at NGPs, radically different story, you have these extended periods, multi-year periods of potential research and development, scaling up production, doing all kinds of trials and testings, working on new distribution, raising consumer awareness, spurring trial on adoption. eventually you know incentivizing getting people to switch over and at the same time you have other competitors that are maybe aggressively trying to win over the consumer as well so they're undercutting you on price or they're being more aggressive on whatever they can do to get you know their product in front of the eyes of adult consumers or operating illegally with uh the elf bar i think uh yeah so so you know there's no doubt you look at these pressures and yeah there's some real concerns here and the there's real future questions about well what is the pace

Starting point is 00:50:45 of innovation look like for any of these products do these companies continually have to invest more in R&D? Do they have to continually do more to get those new versions out in front of the eyeballs of customers? Is there going to be the same degree of pricing power when there's potential new entrants, new degrees of competition? And again, I think if you look at all of the different factors that go into value creation, you can look at the volume dynamics, relative excise tax differentials between legacy and next gen products. You can look at relative pricing, look at all these things. And, you know,

Starting point is 00:51:24 I've written on those details rather extensively on invariant and you can draw some conclusions where you go, Hey, even if things aren't all sunshine and rainbows, you can get some pretty great returns potentially when you look at the multiples of today. And again, you're looking at companies that are trading at six, seven, eight times free cash flow. And certainly some are generating far less free cash right now than they're potentially capable of because they are reinvesting at rates far above their historical norm, which could very well continue to varying degrees. At the same time, you also have others that go, hey, we are trading at a terribly low multiple, so we're focused on returning capital to shareholders.

Starting point is 00:52:22 We're not only paying a sizable dividend, but we are laser-focused on share repurchases. And we're not just talking token repurchases. We're talking about retiring 5%, 6%, 7% of equity capital per year. And the thing I find most compelling is right now, I think people are not looking at this for some of these names as the simple math problem it is. Like if you're concerned about cigarette price take, not being able to offset volumes and looking at the core business of some of these names starting to peak and then decline, say, in perpetuity. Okay, well, map out the different trajectories for that decline. And now look at how fast they're retiring share capital. now which one is

Starting point is 00:53:24 falling faster and there are a couple of names where you can paint really wide range of scenarios in which the number of shares is falling much faster than the operational performance

Starting point is 00:53:40 is falling and so you go well on a per share basis these things have room to potentially grow rather significantly over the next X number of years along with that you know i i know some people they say oh there's no terminal value because cigarettes are just in constant decline and you know at some point there's gonna be nothing left which is always a very odd argument because really like the argument of no terminal value

Starting point is 00:54:07 like terminal value is really just shorthand normally in like a standard dcf or like post 10 years out right and every company has no terminal value eventually that's right nothing nothing lasts forever right i wrote a piece maybe two years ago called nothing lasts forever right um and but the idea that you know cigarettes aren't going to be sold 10 or 20 years from now that's one not true two you know you got to have an idea of not just the volumes but Again, the cost and the price, price of sale on those volumes, along with everything else, you know, plenty of these companies, you look at Altria, they have Bud, Bat, they have ITC, Imperial, they have Log, right, like sizable stakes in other companies. Along with that, while for all these companies, cigarettes are the majority of their operating profit, they have oral tobacco, they have, some have cigars, they all have different versions of next gen products. And you can have different views on trajectories for the profit profiles for each of those.

Starting point is 00:55:11 But again, when you blend them in the aggregate and kind of look at the evolution of the industry as a whole, you can see that the total industry in terms of demand for nicotine and the total profits being generated are most certainly not matching simply the volume decline rates of just cigarettes in one specific country. Which, again, I think those things are often just conflated by a lot of. Why do you favor a basket approach for the nicotine sector? Good question. Yeah. Yeah, I've written. I think it's often in my conclusions. I talk about not just the company, but, you know, how I see it fitting into this. I call it the basket. Right. And I've had a lot of people reach out to me asking, oh, you know, this company is clearly the winner. Why don't you own just it? And, you know, I spend a lot of time studying these companies. I'm not sure anything is so simple as that. And again, the industry, when I think of like who's competing against who, I don't look at it just as this basket of large manufacturers competing against one another. It's really, if you look at how they've behaved, yeah, they engage in different degrees of promotional spend and there's this ebb and flow of market share in the legacy categories. But they all exercise price take very rationally, almost in tandem, all like they're all playing the same game together, just milking those profits.

Starting point is 00:56:55 Along with that, it's really the question I'm looking at is with the change in introduction of NGPs, potential change in regulation, do the advantages that major manufacturers have hold up versus all of the potential new entrants, such as the massive distribution footprints, the expertise in mass scale production, the ability to navigate complex regulatory environments, all of these things. And so I find by taking a basket approach, which mind you, I don't balance all of the names equally in the portfolio.

Starting point is 00:57:44 I do have them weighted. So I do have, you know, companies I'm leaning a little bit more heavily on, right? But when I look at it, I'm thinking, well, what do I like about each of these companies? What are the unique qualities that I find really compelling about them that the others don't have? And kind of creating a weighted approach where getting an exposure to all of the trends that I'm seeing, Whether, you know, it's at different price points, different qualities, different geographies, different frameworks in terms of capital allocation, different growth rates, all of these things, right? Like, it's easier for me to blend it together, take a balanced approach.

Starting point is 00:58:33 Slightly different weightings. I shouldn't say slightly. Some of the weightings are pretty different from one another. But then that, again, allows me to focus on things like the regulation aspects, allows me to look at the innovation on the product side in NGPs and not necessarily look at, oh, in this sub market, look at, you know, company A took one point share and company B from this one product category. You spend all day doing that. I don't know how beneficial that is versus really trying to keep focused on the small handful of variables that will move the needle most for this basket. And again, when you look at the multiples they're trading at, you can take a blended approach. And I'm content with not being 100%, you know, in terms of my total allocation into

Starting point is 00:59:27 the industry, I'm okay with not just putting that all into the one company I think could have the highest return. If I think I have a much higher odds of still getting a very adequate return, again, by taking that basket. I hope that all makes sense. Totally makes sense. Now, I'm curious your take on this one. I wanted to add it in here. I think some people would argue that one of the reasons negatine stocks are down or have done poorly is the rise of ESG mandates.

Starting point is 01:00:01 And as an investor in these companies, would you prefer more or zero ESG mandates? all right here we go um no uh so maybe it was a year ago i wrote a little piece on esg it's called the perils of esg and i will say that most of what people call esg today i don't think is really ESG, right? They're these seemingly arbitrary scoring systems applied by third-party companies that really don't dig into the E, the S, or the G. And it doesn't make a lot of sense to me. I think they're making a lot of money offering those services, creating ESG scores, but it's hard to wrap my head around. And I don't know that it is all that effective at accomplishing what it claims it's a trend to accomplish. What I do think is that investors have an imperative duty

Starting point is 01:01:13 to look at environmental, social, and government aspects of the companies that they invest in, and they think about the needs, wants, demands of all stakeholders, and they figure out their position in the world, both the company's position and their own position. What companies do they want to be invested in? What companies do they think understand the importance of those qualities? But again, it's not just slapping some score or some rubric on anything. It's really understanding stakeholders.

Starting point is 01:01:56 And I think any successful company, especially companies that succeed over long periods of time they understand the importance of looking at all these different stakeholders and i think again successful investors look at these aspects and they understand the importance of doing their own due diligence their own evaluation of these qualities and companies um with that said you know related to these companies i think that the current beast current iteration that is the esg movement you can see that becoming potentially a bigger headwind for the industry i could see that leading to less capital being willing to invest in industry

Starting point is 01:02:43 therefore multiples compressing even further you know i've read a handful of investment theses over the last year. People talking about XYZ company will grow their reduced risk portfolio to X amount. Therefore, it will re-rate because it will suddenly be ESG. And yeah, when you paint an exit multiple, triple the current multiple. Any company can look pretty good for an investment, right? But I really think pessimism could continue to mount here. I see no reason why multiples would radically expand. Not to say they can't, but I will not take that as a given. Instead, I look at depressed multiples, hopefully some disciplined spending in terms of reinvestment,

Starting point is 01:03:36 respectable management of the legacy business modest growth of the new business and ideally when you look at the contribution margins of all these products tally it all up and go okay there's going to be a lot of cash at the end of the day

Starting point is 01:03:54 if they repurchase equity at these depressed multitudes again does does the reduction of equity offset the reduction of legacy. It's a race against one or the other. Kind of firmly in one camp,

Starting point is 01:04:14 thinking that the equity is going to win that race by a pretty hefty margin. Yeah, and if there are a lot of mandates out there that keep people out of these stocks in the multiple-stated press, capital returns become very important and the share buybacks come over the needle in a big way. Right.

Starting point is 01:04:31 As we close out here, final question, why should an investor be interested in the nicotine sector in 2024? Yeah, well, so one way or another, you can learn a lot from it. I think the industry is an exceptional case study. You go through the whole history. I mean, it's not new that people are saying the industry is doomed. This is the peak. It's all downhill from here, right? Like they've been saying it for a very long time and that's going to be true eventually right like there's um potentially it could be true at least for legacy right legacy could peak i don't think it's necessarily soon on a global level i think people are way too pessimistic um

Starting point is 01:05:17 but it's a very Good lesson, just understanding the power of brand, the power and the destructive capabilities of capital allocation. I mean, if you study the actions these companies have taken over the last half century of divesting away from the core business, um you compare the companies that heavily divested into other industries versus those that aggressively retired share capital you look at those that focused on international expansion versus focus focusing strictly on their domestic market right there's all these different factors and um and i think there are some timeless lessons there i think if you look at the industry now i I mean, I find personally some very compelling numbers and narratives attached to a handful of these companies.

Starting point is 01:06:17 I write about them fairly extensively. And likewise, there are also some really interesting growth stories. Again, in the NGP space, whether it's certain manufacturers, certain distributors, certain retailers, there's certainly going to be a lot of value produced by the industry. how exactly that gets split carved up shared return to shareholders you know that can be a whole different question but um i think it's a deeply misunderstood industry anytime an industry is deeply misunderstood or disregarded that's probably you know fertile hunting grounds for for an investor willing to do the work yeah the fact that almost all these products have great unit economics and people don't seem to understand that nicotine volumes are pretty

Starting point is 01:07:09 stable around the globe, that it doesn't mean every stock is going to do well. Some managers could be boneheaded, as we know. But yeah, that's, as you mentioned, a fertile hunting ground. Now, wrap things up here today. Thank you again for joining. As a reminder to the listeners, where can they find more of your writing yeah i really appreciate you having me on it's been a fun chat yeah you can always find more of my writing at invariant.substack.com go ahead and just google devin lasar invariant if you forget that url i i show up and uh yeah i'm on twitter you can always connect with me on twitter at devin lasar yep well i have the link to those in the show notes. Also, you've done a couple episodes of the Preferred Shares podcast,

Starting point is 01:08:03 diving deep into business history with, I know one of the other person's name is Lawrence Hamtel, the other guy's name, I forget. Douglas, yeah, the three of us, diehard history buffs, business history buffs. So you can go ahead and find the Preferred Shares podcast. We do a good job, I think, diving into some of the lesser known or slightly more obscure stories of business history and find some compelling case studies of things going very right or things going very wrong for certain businesses or industries. Yeah, it's an endless history. And anyone that listens to this show would like that as well. Let me get the disclosure out of the way. We are not financial advisors. Anything we say on this show is not formal advice or recommendation.

Starting point is 01:08:49 Ryan, I, or any podcast guests may hold securities discussed in this podcast, may have held them in the past, and may buy, sell, or hold them in the future. Thank you again, Devin. And we'll see you all next time. Thanks.

Chit Chat Stocks - The State of the ~NICOTINE~ Industry With Devin LaSarre

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.