A Discussion to Help Equip Current and Prospective Lenders to the Tobacco Market
On this podcast Jason Gomes provides an overview of the tobacco industry with an emphasis on recent trends, regulatory factors and areas of focus for lender due diligence.
Steve Katz 00:16
Hi, everybody, and thanks for listening in on our Hilco Global Smarter Perspective podcasts. I’m your host, Steve Katz. And we’re glad you could tune in today, we’re going to be discussing some pretty important considerations for lenders that have existing or prospective borrowers involved in the tobacco industry. And joining us for that conversation is Hilco Valuation Services Valuation Director, Jason Gomes. Jason, thanks for joining us today.
Jason Gomes 00:43
Thanks for having me, Steve. Appreciate it.
Steve Katz 00:45
Yeah, we’re really glad to have you on and we haven’t really covered, we’ve we’ve covered some cannabis related topics in the past, we haven’t really taken time to dive into tobacco the way we’re going to talk about it today. And there’s obviously quite a bit going on in the industry with the continued evolution of E cigarettes and the regulatory considerations that are associated with that and traditional tobacco. So sure, there’s much more that’s challenging both operators, and is also concerning to lenders. So let’s get rolling. I think it’d be great if you could just talk a little bit about how consumption of tobacco products has been trending recently, and then take us into some of those other developments.
Jason Gomes 01:28
Sure, Steve, that’s a great place to start. So about 20 million US adults aged 18 years or older smoked cigarettes in 2021. That’s close to 11 12%. And while that may seem like a fairly high percentage, given current medical knowledge, you know, widespread smoking education efforts, and Americans increasingly healthy mindset, this figure represents a substantial decrease from a whopping 21% as recently as 2005. So regardless of regardless of how you feel about smoking, this is a precipitous decline. In other regions like Europe, Asia, South America, rates have declined as well, but not to the degree that we’ve seen in the States. And furthermore, sales for the cigarette and tobacco products wholesaling industry has shrunk significantly. Over the past five years, wholesalers have had to deal with continually expanding regulatory and micro and macro economic challenges as well as shifts in consumer preferences. So due to these factors in such a rapidly changing landscape, wholesalers have had to expand their product portfolios to capitalize on the explosive popularity of E cigarettes. These products have helped to partially offset declines experienced by the industry within their traditional cigarette to and other tobacco product lines. Yeah, e cigs popularity particularly among teens and young adults have skyrocketed over the last five years or so, which has driven you know, concerns from parents and legislators, hence the increasing legislation. But the sick trend can really be traced back to more than 10 years ago, pretty much when the industry began. I remember working on evaluation of an e cigarette manufacturer about 10 years ago. And the products have come a long way in terms of how they’re consumed different flavors, packaging colors, etc. It’s a huge market now. So, you know, although smoking rates have plummeted, E cigarette use has helped to maintain steady sales overall and demand for other non cigarette tobacco products such as premium cigars, cigarillos, snuff has also been persistent, but still revenue for the cigarette and tobacco products Wholesaling industry has declined that a compound annual growth rate of 1% or so over the past five years, which is I think it’s about 150 billion that it hit in 2023 if I’m Correct. And it’s expected that, you know, given factors associated with inflation, 2023 alone, we’ll see a revenue decrease in the range of 1.6% or so, it doesn’t seem like much, but in such a large industry, it is a it is a decent chunk.
Steve Katz 03:59
Okay, so that’s perfect. Let’s sort of focus now on that regulatory environment, which obviously, you know, is quite complex, specifically as it pertains to the E cigarettes or E cigs as you call them. So maybe we can talk a little bit about that.
Jason Gomes 04:15
Yeah, sure thing. So regulations related to the cigarette and tobacco products continue to grow across the nation. It’s been an ongoing thing, primarily at the state level. For instance, I recall in early 2022, Massachusetts implemented a ban on all flavored tobacco products, including menthol cigarettes. I remember speaking to some folks who began driving in New Hampshire to get their menthol so it wasn’t a cure all but certainly a barrier to new and younger smokers. I think that was you know, the goal. In other locales, and municipalities have imposed severe restrictions on where smoking is allowed, including many outdoor and public venues. Obviously, indoor locations such as bars and restaurants. They don’t allow smoking but of course they used to and so things have to changed against so much has changed, really and continues to change when we talk about tobacco products, you know, the youth who are using these products, etc. So,
Steve Katz 05:08
Yeah, skewing a lot skewing a lot younger now for sure.
Jason Gomes 05:11
Yeah, you know that, you know, all that being said, it’s safe to say the pressure continues to mount right across the country on anything tobacco product related. In this, you know, this is one of the the reasons consumers have transitioned to E cigarettes or vaping, which is considered by some to be less harmful, although, you know, as they’re, they’re less harmful, harmful, because they’re non combustible products, basically, without many of the traditional chemicals will find it cigarette, but they’re also vaping to wean off traditional cigarettes. So sort of a substitute to try and get off that traditional product. Obviously, there has a lot of health impacts there.
Steve Katz 05:49
Yeah, I know, we’re seeing more and more people who at least I know used to smoke, and then carrying some version of e cigarette vaping type product to at least it seems like what they’re trying to do is wean themselves off that way.
Jason Gomes 06:03
Right, yeah, and a little more on regulations, at the federal level rules pertaining to the set, the use of E cigarettes are still a work in progress, really, the US Food and Drug Administration first assumed authority over these products only, I think it was 2016. So that’s relatively recently. In the five years kind of leading up to that point, saw exponential growth in the production and popularity of E cigarettes. I think, in fact, according to the CDC, a 120% increase in the sale of those products took place in the span of I think it was between 2014 and 2020.
Steve Katz 06:43
Really, really incredible.
Jason Gomes 06:45
Right. And I think even more recently, it’s it’s grown even even further. So it’s, it’s a, it’s a really a very rapid expansion, the market for E cigs. And it helped this market help significantly boost wholesale profits during that time, and other stringent regulatory environment that’s now taking hold, combined with the continued social stigma of smoking and tobacco use overall is widely expected to further I would say, the reduction of traditional tobacco products in the consumption over the next five years and beyond them for sure. So I think for any lender, any potential lender, they should be aware of this, obviously, this changing consumer landscape and regulatory environment. When considering extending credit with a traditional tobacco distributor or manufacturer, I think that’s important to know, in the ever, I mean, the ever changing risks related to regulation and consumption alternatives, add to the uncertainty of a declining industry, and should definitely be monitored closely by any potential lender.
Steve Katz 07:52
Alright, all good points, I think, and very relevant to the listeners, particularly those who are lenders out there who follow these podcasts. So the question is, what can a lender really do to protect itself? Right? From a diligence perspective, other perspective, what what insights can you share on that?
Jason Gomes 08:13
Right? Diligence is certainly critical, Steve. First of all, I think we would advise diving into or looking at the nature of the business seems obvious, but this is key, understanding the specific nature of the operations of a tobacco consumer products company as early as possible in the due diligence process. That will be key to a successful inventory appraisal outcome, it’s critical understand that the company’s primarily a manufacturer of items such as cigarettes, or chewing tobacco, or are they a distributor of these products. Do they produce or distribute a variety of products or accessories such as lighters? Or are they solely as cigarette maker, or tobacco to producer who, who the customers do they sell to distributors who in tell turn sell into the convenience store and gas station marketplace. This is referred to as the measure market by tobacco manufacturers. Or perhaps they’re a smaller regional company that sells directly to such retailers. So it’s certainly critical for a lender to fully understand the landscape channels of distribution and footprint of operations of any given company in this space. As you know, this can have a direct impact on inventory valuation.
Steve Katz 09:29
Right a lot of different configurations, different different types of businesses and ways that they can be involved in the market. So a lot of variables for lenders, what else?
Jason Gomes 09:39
Some of the key products if you want to get into that, I think the most common forms of chewing tobacco. Let’s start with that. It’s what’s called moist snuff tobacco MST or commonly known as dip, often in a variety of flavors and packaged in this hockey puck like plastic container and then there’s the more traditional loose leaf chewing tobacco which consists of shredded tobacco leaf which is usually sweetened by the manufacturer of sometimes flavored and mainly sold in a sealed pouch. In the cigarette world, there’s approximately 25 brands of us cigarettes sold across the country. A lot more than than that globally, but domestically, that’s about where we’re at. Typically, you get 20 cigarettes a pack. Recent trends suggest that consumers will be trading down from premium looseleaf chew to more premium MST in cigarettes premium cigarettes to discount brands, mainly due to worsening macroeconomic conditions and a potential recession. So as a result of that, you know, discount product segments are poised to reap the results of this growing prospect in the coming quarters. So I think lenders must, you know, they really should understand potential issues associated with product exploration across a variety of these product offerings that I’ve just discussed, as well. I think it’s important to note. So give you a couple of those just. Yeah, it’s typically loose loose leaf chew expires after 12 months post production. Think dip are more moist snuff tobacco expires after six months and cigarettes after 24 months. So I think lenders must be aware that inventory expired or nearing expiration may require significant discounting and may be subject to limited distribution channels and liquidation. So aging is certainly something aging and expiration certainly something to keep in mind.
Steve Katz 11:36
Yeah. Okay, so, so perfect transition, I think, you know, when you talk about any businesses, especially things that expire, things that do have a definitive shelf life and can’t be, can’t be put in the warehouse and brought back to life, for sale another day, you know, five years down the line, things get a little more complex. So what about maybe just dive a little more into some of these aging issues and other inventory oriented concerns for lenders.
Jason Gomes 12:06
Sure, I think it’s worthwhile to discuss the raw material tobacco, you know, before it becomes an actual product that we’ve discussed thoroughly here. But, you know, raw material tobacco is commodity like in nature. So think soybeans, dairy, eggs, meat, items like that which trade on a commodity market, in tobacco requires what’s referred to as a natural aging process. This lasts between two and three years, believe it or not, during the aging process, tobacco undergoes two sweating processes, which typically occur in the spring and late summer fall. And then there’s this, you know, this curing and subsequent aging, which follows that and it allows for the slow oxidation and degradation of carotenoids in the tobacco leaf itself. So tobacco is then after that process is completed, then stored in wooden barrels called hogsheads. This is to complete the aging process. So they almost looked like wine cans if you’ve ever seen one of those.
Steve Katz 13:08
Jason Gomes 13:09
Yeah. But it’s Yeah, so it’s important for for a potential lender to understand where in the aging process the raw, the raw material tobacco is, during the diligence process, as well, to better understand the potential for sale and liquidation think that’s important. I’ve seen these hogsheads a number of times where you know, where the tobacco is stored, and it’s at some storage, facility storage and aging facilities, they simply write the age on the outside of the barrel is updated as time goes on. So it’s not necessarily a sophisticated or automated system necessarily, that’s in place at these facilities. So I would say lenders should, should certainly take note of that as well. And one last thing on tobacco, which is not yet fully sweated, cured or aged, may not be as soluble is that tobacco, which is completed the process, which is a true commodity designation, that seems obvious, but you know, it’s a long process. So sometimes, it does take a while to get to that final state.
Steve Katz 14:07
Okay, great. So what about you know, again, it’s we’re talking about a sort of a natural you know, more natural product here. So, what about harm that can be caused by pests or other outside influences associated with nature?
Jason Gomes 14:23
Right So there Yes, I agree. There’s there are certainly pests or things in nature that may impact the crop so I think one to note is a pest called Lasioderma serricorne, better known as the cigarette beetle. The cigarette beetle is always a concern facing tobacco storage facilities, these tiny critters, typically like two to three millimeters long, they can infiltrate quickly and cause significant damage to the crop if still those looking after the tobacco do not take the proper precautions. So storage vendors must regularly fumigate warehouses proactively in some cases retro actively as its fine balance here preventing the beetle infiltration. One example is that we recently visited one of the largest, better run tobacco aging storage companies in Tennessee. And they walked me through their beetle risk mitigation process. And I witnessed firsthand the kind of damage that such small insects can can cause to the tobacco in a relatively short amount of time. So it wasn’t…
Steve Katz 15:27
You definitely know it’s a problem when they have something called a beetle risk mitigation process.
Jason Gomes 15:33
Yeah, I mean, you think it’s it’s not a big deal, but it really can be. So there, these warehouses are really spot clean. And still, these these problems do arise from from the insect. But yeah, that the warehouse that I was at, they had a small problem with it. They typically have it from year to year. But, you know, luckily, they caught it early enough and damage was minimal, but they really need to stay on top of that, for sure.
Steve Katz 16:00
And what about market pricing? The nature of inventory?
Jason Gomes 16:06
Yeah, it’s important and it’s that’s a good segue from the commodity tobacco. So clearly, any potential lender should monitor the commodity price for tobacco on a regular basis, particularly if the company is a manufacturer and carries or owns a significant amount of raw tobacco on hand, or being aged a third party vendor. Secured lenders should also understand what inventory categories are commodity like within a tobacco producers overall product mix. Commodity like inventory generally has a very large potential customer base and liquidation scenario and generally requires relatively minor levels of discounting below market price to incentivize purchasing, but also on the flip side of that rapid decreases in market prices for such a commodity can leave a company carrying inventory at a high cost basis relative to current market prices. And although the commodity market price for tobacco has been relatively stable in recent years, you know, bad crop or certain adverse weather patterns may have a negative impact on the harvest and could lead to pricing volatility. One last point on this, I think it would also be wise for any commodity driven business to engage in some form of commodity futures hedging to mitigate the risk of pricing volatility. So I would, you know, a lender would be advised to, you know, understand if any hedging activity is involved in the company they’re looking at in a potential engagement.
Steve Katz 17:38
Yeah, that that last item is a good point. Definitely an important consideration for lenders. All right, well, we are just about out of time, anything we didn’t touch on that you wanted to pass along?
Jason Gomes 17:50
Yeah. A couple of quick but important final thoughts here. First, related to the costing of inventory, we’ve discussed inventory and length but inventory costing methodologies across set different segments such as raw material, working process and finished goods should be thoroughly understood including the impact related to ever changing commodity inputs costs as I mentioned earlier, so this includes an understanding whether inventory is costed standard or some other method in which components are included you know, is it labor freight overhead federal excise taxes, duty, you know what’s in that standard, this would be a critical item in inventory valuation just trying to differentiate and understand the differences there. Also, as information on a potential borrowers is gathered, I’d recommend that the lender share this information with the appraisal firm prior to appraisal engagement. As early as possible sharing this info tends to facilitate a more efficient process in areas such as initial inventory, recovery and guidance and just general report setup and lastly one other item I think is worthy of mention is related to a assortment mix. Any I would say any potential lender should definitely monitor the the inventory level mix frequently, a finished goods would recover at a higher rate than raw material tobacco in a sale. Therefore shift in any mix from finished goods to raw materials would have a negative impact on the overall recovery valleys, the blended recovery valleys provided liquidation. So in this industry in the tobacco industry companies do tend to carry significant amounts of raw age and sweated tobacco, but that you know, this product still being that it’s a commodity tends to recover quite high. So that’s that’s also important to know, in you know, I recently valued a large publicly traded Quebec tobacco consumer product manufacturer and over 50% of inventory was raw material tobacco, but as mentioned, you know, that’s there wasn’t necessarily hindrance to their recoveries, because it is such a commodity. So, you know, we would certainly recommend that any lender establish separate advance rates for finished goods and raw materials, which would capture changes to inventory valuation due to any inventory mix shifts.
Steve Katz 19:59
Yeah, that’s an excellent point. Not it’s not the case for every industry, obviously. So, right. That’s a really good point. And you know, just one of the many things that lenders really need to understand about this market, which is why we were glad to have you on. So thanks for joining us today, Jason, to share all this information for lenders to the tobacco market. And if any listeners do want to reach out to you with a follow up question, what’s the best way to get a hold of you?
Jason Gomes 20:24
Yeah, sure. I can be reached by email or phone. My email is [email protected]. So that’s J G O M E S at Hilcoglobal.com. And my phone number is 857-403-3093.
Steve Katz 20:41
All right, perfect. Great info. Really appreciate you joining us and listeners, if you’re lending or looking to lend into a business that’s involved in the tobacco industry. I think as you can hear from what Jason summarized, I’m sure just briefly today, there’s a lot of information that you need to know and can really assist you in your efforts. So, as always, we hope this Smarter Perspective podcast provided you with at least one key takeaway that you can put to good use in your business, or share with a colleague or client to help make them that much more successful moving forward. Until next time for Hilco global. I’m Steve Katz.