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

Shares - - CONTENTS - By James Crux

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

(B5ZNQ99) fund.

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.

CON­SUMP­TION TRENDS

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.

COM­PELLING ECO­NOM­ICS

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.

LARGE MAR­KET

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.

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