Can shares in tobacco companies fight back after a torrid time?
London’s listed tobacco titans are determined their high returns won’t be vaporised
Once considered defensive investments and dependable sources of income, tobacco stocks have recently gone through a troublesome period and experienced significant share price declines.
Cigarette companies were long-prized for their strong brands, pricing power, high margins and strong returns on capital, a function of the fact smokers are addicted and willing to stump up premium prices for their brands.
Yet shares in the Londonlisted British American Tobacco (BATS) and Imperial Brands (IMB) have de-rated on fears over declining cigarette volumes, the economics of socalled Next Generation Products (NGPs) and the implementation of a nicotine standard across the pond.
Increased health awareness, decreasing social acceptance of smoking and legal and regulatory changes, including the introduction of plain packaging in numerous countries, have steadily reduced volumes.
Also weighing on sentiment is the fact tobacco stocks are considered ‘bond proxies’ and have sold off amid rising government bond yields.
HOW ARE CIGARETTE COMPANIES FIGHTING BACK?
In reaction, ‘big tobacco’ is aggressively investing in NGPs, which bears argue are beginning to cannibalise the profitable combustible tobacco business.
Put simply, the epochal shift from conventional cigarettes to NGPs is driving the biggest changes this sector has seen in living memory.
Yet many well-followed portfolio managers are sticking with the London-listed duo. Neil
Woodford holds Imperial Brands and BAT (British American Tobacco) in his LF Woodford Income Focus Fund (BD9X6D5).
Mark Barnett holds both stocks in Edinburgh Investment Trust (EDIN) and BAT is a leading holding in the Michael Clarkmanaged Fidelity MoneyBuilder Dividend Fund (B3LNGT9).
The pair also features in the Colin Morton-managed Franklin UK Equity Income (B7DRD63) and Franklin UK Rising Dividends (B5MJ560) funds, while BAT is a long position in the Nick Osborne-steered
BlackRock UK Absolute Alpha
We’re taking the view that all the bad news is fully priced into the two UK-listed tobacco stocks and that now could be a good time to buy the shares.
GOING UP IN SMOKE?
Investor sentiment towards the sector is cautious to say the least. ‘The market doesn’t like the uncertainty the introduction of NGPs has presented and the increased regulatory oversight from the FDA (US Food & Drug Administration),’ explains BlackRock’s Osborne.
This is on top of illicit trade – a perennial industry headache – and rising regulation in developed markets, all factors behind steady volume declines as population growth remains muted and smoking prevalence continues to fall.
Emerging markets remain promising due to fast population growth, increasing disposable incomes and less-stringent regulatory environments.
Yet even some emerging markets are becoming more aggressive in their tax treatment of cigarettes; recent major tax hikes have been pushed through everywhere from Russia and Brazil to Saudi Arabia, Indonesia and the Philippines.
Last summer, the FDA announced it would move to ‘harm reduction’ as the basis for regulating the US market and look at the feasibility of reducing nicotine to non-addictive levels in US cigarettes, potentially going far beyond previous attempts to reduce tar and nicotine levels.
CHANGING FOR THE BETTER?
Bulls insist the industry is at the start of a long transformation, one that should enable it to become less controversial and enjoy a higher rate of sustained sales growth.
The shift to NGPs is sure to be slow, with many hopelessly addicted consumers likely to remain cigarette smokers long into the future.
There is also evidence that public smoking bans and declining affordability are the major causes of volume decline, rather than a dramatic shift in societal attitudes.
Berenberg analyst Jonathan Leinster points out demand for nicotine is actually rising, and not declining.
‘In our study of 12 major markets, the number of smokers of conventional cigarettes (aka factory manufactured cigarettes or FMC) has declined by about 1% per annum over 2010-18, but the total number of users of vaping, FMC and heated tobacco combined has risen over the same period,’ he explains.
‘This may be double counting dual-users who both vape and smoke, but even if we assume 50% of vapers are dual-users then the total number of consumers is flat over 2010-18.
‘Retail sales of FMC, in US dollar terms, rose 1% per annum over 2010-18 in these markets and rose 2.4% per annum for the combined categories.
‘This does not take into account the rising number in volumes of oral tobacco and cigars in the US. Overall, the demand for nicotine is rising and consumers are spending more. The issue for the industry is that governments have become increasingly aggressive at maximising tax revenues and taking a larger share of the gross revenues.’
The demand for nicotine is rising and consumers are spending more. The issue for the industry is that governments have become increasingly aggressive at maximising tax revenues and taking a larger share of the gross revenues
There are few (if any) low-ticket “must-have” consumable products that one billion people desire on a repeat basis at the same scale and pricing power as tobacco
Tobacco titans are tackling the threat head on by creating NGPs they can demonstrate are less harmful to consumers.
Their strategy is based on the fact regulators broadly accept ‘harm reduction’ as a regulatory framework as this implies a greater ability to innovate and market products that are less damaging to health and critically, for a differentiated tax system for them. Bulls believe NGP can and will be profitable, among them the Berenberg analyst.
Leinster believes investor concerns about the future profitability of NGP markets are overdone, the focus on margins misplaced and worries about new entrants ignores the opportunity ‘big tobacco’ will have against smaller national players and illicit trade.
Big tobacco has already developed products that have gained widespread consumer acceptability in both vaping and heated tobacco, notably Philip Morris International’s
iQOS product, BAT’s Glo device and JUUL.
Liberum Capital argues that both BAT and Imperial Brands trade at the widest discount to the Consumer Staples sector in over 15 years despite their improving prospects.
‘Shares are so depressed that we believe the market is discounting a nicotine standard far earlier than the FDA can reasonably deliver,’ thunders Liberum. ‘Our base case assumes the US nicotine standard comes in 2023. We see significant upside on conservative assumptions.’
For those unfamiliar with the sector, it is worth re-stating the compelling economics of the major international tobacco manufacturers, which remain intact, for now.
‘There are few (if any) lowticket “must-have” consumable products that one billion people desire on a repeat basis at the same scale and pricing power as tobacco,’ says Liberum.
‘Cigarettes are cheap to produce at scale and travel well. Tobacco growers and distributors have weak bargaining power.
‘Tobacco companies’ attractive positions are further entrenched by advertising bans, which makes it difficult for new entrants to steal share. This industry structure and the addictive nature of the product create a highly favourable pricing and margin structure for manufacturers.’
A further strength is that the cigarette industry is highly consolidated. Stripping out China, India and the US, 84% of the global market is spoken for by four players – PMI, BAT, Japan Tobacco and Imperial Brands.
While the consolidated structure of global tobacco makes it more difficult to get regulatory approval for further mergers & acquisitions (M&A), it also means there are fewer price wars among legal competitors, a trait that supports high profit margins.
Bear in mind that cigarettes are a $683bn global market – that is the retail value based on the 5.5trn cigarettes the tobacco industry sold in 2016.
More than 1bn people smoke globally. That is roughly 15% of the global population or 20% of the world’s adults.
According to Euromonitor, the fastest growing tobacco markets by retail sales are China, Russia, Indonesia, Turkey, Argentina, South Korea, Egypt and Iran.
Colin Morton has been adding to both London-listed stocks in his Franklin UK Equity Income and Franklin UK Rising Dividends portfolios. He says that over a long period, they’ve both produced very good dividend growth and dividend yields and both have very good free cash flow yields and strong market positions.
Whether NGPs present a challenge or an opportunity is ‘the million dollar question’, chuckles Morton. ‘Will they end up being the market leaders in NGPs and will they be able to make the same margins and profitability?’ he rhetorically asks.
Morton believes that a lot of the bad news is already in the price and he is willing to take a risk that more likely than not, BAT and Imperial will be the winners no matter what happens.