Still puff left in tobacco

Cigarette giant British American Tobacco (BATS) grew profits by 4 per cent to £5.8bn last year on revenues up 1 per cent to £15.3bn. That's impressive considering many believe tobacco to be a shrinking industry marred by bad publicity. The strategy, BATS says, has been a focus on price-mix improvements and growing market share, particularly in more exotic locations such as Bangladesh, Pakistan and Vietnam. Volumes in Western Europe, meanwhile, slumped by 8 per cent, as the recession forced chain-smoking southern Europeans toward cheaper brands.

The increasingly health-conscious developed world is clearly no help to Big Tobacco. Regulation in western economies only grows more punitive and ‘plain packaging’ graphic warnings will serve as a further deterrent if introduced in the UK. It already exists in Australia, and Ireland is in the process of rubber-stamping legislation.

And latest trends in US healthcare pose a brand new set of challenges, and require some discussion here. As more US citizens are absorbed into the national healthcare system under President Obama’s reforms, city-based hospital emergency rooms face serious capacity pressures. As Britons served by the long-established NHS, we can easily identify with the woes of people-packed emergency rooms, but the US is facing these issues more than 50 years behind us. As a result, US drug stores - the equivalent of Boots or local pharmacies over here - will expand their existing walk-in clinics to take some of the load off struggling A&E departments. But that does mean they face an impossible contradiction - under the same roof, patients can check their blood pressure and buy a pack of cigarettes on the way out.

CVS Caremark (US: CVS), the drug store currently listed on the New York Stock Exchange, has recognised the problem and, arguably, set the example. Its 7,600 stores across the US will stop selling tobacco products this spring and have removed all tobacco-related products by October. It follows the Center for Disease Control and Prevention's unsurprisinging conclusion that tobacco is the single largest preventable cause of death in the US. Mr Obama - a former smoker - has publicly praised the decision by CVS.

So, Obamacare hates smokers, but while CVS estimates pulling tobacco products from its shelves could cost it $2bn (£1.2bn), a 50 per cent increase in healthcare premiums for smokers under the new Affordable Care Act (ACA) offers a massive growth opportunity for CVS. It already recorded over 3m 'check-in' visits by its pharmacists to current customers, but could see this number accelerate as US citizens become eligible for state-paid treatments. Additionally, the CVS ‘MinuteClinics’ currently clock 4m annual visits, but this will undoubtedly grow under Obamacare as companies move retirees onto private healthcare exchanges. CVS estimates that it already has clinical relationships with 82 per cent of people eligible to use Obamacare health cover.

Of course, tobacco companies knew the revolt was coming, but they hope to make some money from smokers looking to quit. E-cigarettes have been regarded as Big Tobacco’s emergency lifeline, but the City is not so sure. CVS doesn’t currently sell e-cigarettes and has stopped short of saying whether it will do so in future, leaving global manufacturers in limbo. More importantly, the US Food and Drug Administration (FDA) continues to delay new guidance on the safety of e-cigarettes. Until that is published, CVS refuses to make a final decision over whether to sell the new products.

If sales of e-cigarettes in the US go ahead, British American Tobacco and its UK-listed peer Imperial Tobacco (IMT) can take a deep breath. Both companies have admitted the future lies in embracing a tobacco-free world. BAT launched the first electronic cigarette product, Vype, in the UK last year. While the level of investment into the next generation of non-tobacco products is not to be underestimated, it seems to be paying off for Big Tobacco. Last year, BATS improved the return on capital employed to 31 per cent, up from 23 per cent in 2009.

But the next generation of products is not having an easy ride. The decision to throw money behind a new slew of TV advertising for e-cigarettes in the UK has been met with a serious backlash from an increasingly health-conscious public. And statistics are hardly supportive. While initial research believed consumers would smoke more e-cigarettes than tobacco-filled ones within a decade, figures up to 2012 show that most of those who had tried e-cigarettes eventually went back to the real thing.

Remember, too, that the European Union has just banned menthol cigarettes after the products were deemed to be as dangerous as the original incarnation. The FDA has yet to issue a decision on menthol-based products, but even the developing world appears to be catching on. China - home to more smokers than any other country - has introduced a public smoking ban.

The setting of legislative precedents by global governments is clearly crucial to the future of Big Tobacco. But for all the doom and gloom, the industry is not dead yet. History shows that when cigarette-makers raise prices, smokers still pay and the new e-cigarettes are managing to find a way round tightening regulation in Europe. Pockets of the developing world are helping to offset volume declines in western economies, too, and Big Tobacco isn’t losing its attraction as an investment since shareholders are regularly rewarded with big dividends and share buy-backs.

IC VIEW:

Tobacco is not the industry to invest in for growth. Plain packaging will inflict significant damage and CVS’s decision in the US is likely to be copied elsewhere by governments keen to appease a health-conscious electorate. There is only a small market on offer for next-generation products in the meantime, and the cost to tobacco companies to remain competitive will not be small. Yet, despite these obvious threats to growth, Big Tobacco continues to offer hefty dividends for income seekers.

FAVOURITE:

Imperial Tobacco (IMT) is lagging behind in the arms race that is launching next generation non-tobacco products. But this year it will make efforts to catch up with British American Tobacco with the launch of its Puritane electronic product into Boots stores. Out of the two British tobacco companies, Imperial carries the less demanding valuation, with a forward PE ratio of 11. Although analysts only expect earnings growth of 1.4 per cent to 213p in 2014, a significant dividend yield of nearly 5 per cent at the time of full-year results last November should maintain investor interest.

OUTSIDER:

British American Tobacco (BATS) holds the advantage over Imperial, being the first of the two to launch an electronic product, but Vype sales progress has not been made clear despite BATS successful investment in next generation products. What's more, with the UK e-cigarette market only valued at approximately £200m in 2013, there’s only a small and finite market currently up for grabs. Still, a dividend yield of over 4 per cent remains a sweetener.

THE BROKER'S VIEW

Industry volumes are "unlikely to improve until 2015", say analysts at broker Panmure Gordon. Indeed, Philip Morris International (US:PMI) expects them to decline "by 2-3 per cent in 2014", and sees European volumes down by 7-8 per cent. Russian volumes could fall by up to 11 per cent. But the company regards 2014 as "a year of investment" and will accelerate the development of its reduced harm products, targeting a national launch in 2015. Additionally, it intends to launch an e-cigarette in the second half this year.

This has the greatest significance for Imperial Tobacco (Hold, 2,300p price target), reckons Panmure, given its 'greater skew to Europe and Russia'. Imperial’s share price has fallen 4 per cent year-to-date, underperforming the UK market. "Whilst we view the current valuation as undemanding, set against the weak volume backdrop in Europe, and limited 2014 earnings growth we feel the shares look fair value," says the broker. Imperial "remains on track" to deliver its stated cost savings and reiterated its guidance for dividend growth of approximately 10 per cent. For the first quarter of 2014, reported revenue growth of 1 per cent "was broadly in line with expectations". The launch of Imperial’s Puritane e-cigarette brand in Boots is "slightly ahead of expectations and should ease concerns over Imperial being a laggard in the space," the broker claims.

British American Tobacco shares are also down 4 per cent in 2014. "Encouragingly, the pace of illicit growth appears to have slowed, the pricing environment remains strong and BATS should be able to deliver further cost savings to boost margins," according to Panmure. But, given the likely 2 per cent decline in EPS, it believes the shares look fairly priced.