Fears over the regulation of cigarette packets and evidence that economic problems in developed markets can hit the most profitable premium brands have been weighing on the tobacco sector. When we last analysed the sector's prospects almost nine months ago, we expressed our concerns that PE valuations had moved ahead of the industry's long-term average and that investors seemed to have started to avoid the sector despite market turbulence, which usually prefigures a rise in defensive shares such as those in tobacco companies (see Sector Focus: Has tobacco run out of puff? 6 Jun 2012.) Nine months on and the UK sector has produced a total return of 8.7 per cent, which is substantially below the 21.1 per cent from the FTSE 350. But things have changed and a look at the tobacco industry from a global perspective reveals that attractive income is still there to be had at a reasonable price with the added bonus of a possible recovery in earnings as the year progresses. If this happens, driven in part by easier comparisons with last year, then there could be decent returns on offer in 2013 particularly for investors prepared to take an international perspective.
The key reason to seek international diversification in the tobacco sector is to get exposure to the most attractive international markets, products and niches at a time when there is unrelenting regulatory pressure. The biggest drop in tobacco shares last year came in August when the Australian High Court upheld the ban on branded packaging. The fear was that this could cause a spate of bans across the world as countries felt emboldened to challenge international copyright and brand rights. In reality, the pace of change has been slow and the market seems to be getting used to the idea that plain packaging will not have a huge impact on sales - recent figures from small Australian retailers suggest the packaging change has had little effect, other than imposing a direct cost on smaller businesses, according to the Australasian Association of Convenience Stores.
However, different companies face particular sets of problems within their spheres of influence, which can broadly be put into two camps:
■ Litigation - The US-based industry is particularly prone to longstanding litigation. For example,
■ Declining markets - It is unsurprising that the tobacco companies with the highest earnings-based valuations, Philip Morris and
|COMPANY||PE 2013||EPS GROWTH 2013 (%)||DIVIDEND YIELD (%)|
|British American Tobacco||15.0||8||4.3|
|Philip Morris International||15.5||11||4.2|
Source: Berenberg Bank
Buddy, can you spare an e-cigarette?
The developing theme this year is the move by tobacco companies to position themselves in the 'e-cigarette' market. E-cigarettes are plastic tubes containing a vial of nicotine that evaporates into water vapour when inhaled. The theory is that such devices are less harmful than normal cigarettes as no combustion takes place and the e-cigarette user receives the same hit of nicotine as a normal smoker. They are being marketed as a cheaper smoking alternative and as a way of gradually weaning yourself away from the habit altogether. Companies seem to see potential. For example, US firm Lorillard reckons that e-cigarettes will be worth about 2bn stick equivalents, or 20 per cent, to its business within a few years and to prepare for this it purchased Blue ecigs for $135m (£86m) in April last year. It is no coincidence that Lorillard is rated by analysts as having the highest earnings growth potential over the next two years among the US tobacco companies.
British companies have also been picking up new technology in the area. The British American Tobacco-backed Nicoventures snapped up CN Creative in December 2012 and also plans to submit its Nicodex e-cigarette for medical appraisal by the MHRA regulator as an official smoking cessation device. BAT's assessment of the future importance of e-cigarettes is that they will make up 40 per cent of revenues within 20 years.
The ability of tobacco to give investors stable returns is not in doubt, but a more critical approach will be needed this year to assess tobacco companies for the diversity of their businesses. It is possible to wait for a recovery this year to lift earnings, but this is weighted towards the second half and depends to a large extent, at least in the developed world, on the state of the underlying economies. The challenge facing companies is whether they can maintain their historic rate of 10 per cent annual EPS growth in shrinking core markets, which is why companies with exposure to the developing world have traditionally attracted the highest ratings. Nevertheless, investment in new types of non-lethal nicotine products is becoming increasingly important as regulation in the long run begins to affect volumes at a greater rate than companies can compensate for with price rises.
Imperial Tobacco is the IC's 'Old Reliable' tip of the year. The share price has not performed particularly well following tough trading in the first quarter. However, its PE ratio of 11, combined with a forecast total shareholder return (based on predicted dividend plus earnings growth) of 13.5 per cent, makes the shares a compelling 'value' offer. Diversification can come from investing in either BAT or Philip Morris. Both companies offer a blend of high-value brands with exposure to emerging markets, with excellent prospects for shareholder returns - forecast to be over 14 per cent over the next two years. The only problem is that both companies are the most expensive in terms of PE in their respective market segments.
Swedish Match is the smallest of the major European tobacco companies. It earns around 60 per cent of its operating profits SEK3.36bn (£336m) from snus, a small pouch of chewing tobacco much used by Scandinavians. Snus competition has been hotting up, with signs of consumers downtrading to cheaper brands. The issue is evident in the share price. While Swedish Match's PE ratio is still at a 5 per cent premium to the rest of the sector, it is close to an all-time low for the company, according to analysis by Natixis. The possibility for shareholder returns is what stops the shares from falling lower. Swedish Match shareholders are forecast to receive returns of 15 per cent up to 2014; the highest in the sector. Still, other shares offer better initial value.
Erik Blomquist, tobacco analyst at Berenberg Bank.
The main feature of the sector late in 2012 and early this year has been lacklustre earnings growth, particularly when compared with other consumer staples such as beverages. The Australian decision in August on plain packaging is the starting point for the underperformance of tobacco shares, but this year should see a return to better share price performance underpinned by earnings growth, particularly as the worst for Europe is over, or at least close to over. Now that the market seems to be comfortable with the effects of plain packaging, the sector's pricing power should continue to underpin cash returns to shareholders, which are increasing as a proportion of total income across the board. For example, Japan Tobacco is forecast to pay out 50 per cent of its earnings by 2016, US companies are already paying out between 75 and 80 per cent and this rising trend will continue.
Our preferred names in global tobacco are Japan Tobacco and Philip Morris International, with BAT in Europe. Behind this view is the expectation that higher expected earnings growth will be driven by favourable exposure to key emerging market economies and strong brands within those markets, but with valuations well below those European consumer companies. Investor returns are still key and Japan Tobacco is dramatically increasing its cash return to shareholders over the next three years and will buy back about 5 per cent of shares outstanding in the soon to be confirmed sale of the Japanese government's 17 per cent stake. Operationally, Japan Tobacco's international business grew constant cash profits at over 16 per cent over the last two years, driven by its position in Russia, a market that is among the most attractive in the world due to tax visibility, strong pricing and low price elasticity.
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