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Last gasp for tobacco stocks?

Tobacco stocks present a conundrum. Next-generation electronic products aren't gaining traction and traditional manufacturing is in crisis. But investors might still like to take advantage of the attractive income profile offered by London-listed companies in the sector.
October 17, 2014

As befits their status as so-called 'vice' stocks, the listed UK tobacco companies do have their attractions. Shares in industry heavyweights British American Tobacco (BATS) and Imperial Tobacco (IMT) yield between 4 and 5 per cent. And with capital values on the wane, income generation is now being prioritised by retail investors. In August, the Investment Management Association (IMA) said its best-selling funds sector was 'UK Equity Income'. It recorded £376m of sales, £92m of which related to individual savings accounts (Isas). In fact, that was the third consecutive month UK Equity Income topped the IMA's list.

But income aside, is it a smart choice investing in an industry that has been plagued by bad news and poor publicity? After all, the headlines cite volume decline, emerging markets woes and regulatory pressures as growing challenges to the industry. However, shares in both British American Tobacco and Imperial Tobacco have performed strongly since the start of 2014, which suggests they continue to be popular with the market despite negative publicity. In fact, 'big tobacco' continues to be demonised - and not just in western markets. Recently, the government in South Korea went so far as to file a lawsuit against a group of companies, including Philip Morris International (US: PM). Authorities in Seoul are seeking damages after South Korea's state-funded healthcare schemes buckled under rising costs from smoking-related diseases. As the public health initiatives grow stronger by the day, it's no surprise that tobacco behemoths are pinning their hopes on next-generation electronic cigarettes. But the regulation for these next-generation products is unclear and fragmented, making it more difficult for tobacco companies to forecast accurate growth in this area.

A controversial report from the World Health Organisation (WHO) in August shed light on some of the health concerns associated with ecigarettes. It claimed the vapour emitted from the devices caused nausea, headaches, eye redness and a number of breathing difficulties - particularly for people passively inhaling the substance from nearby smokers. The WHO report said such complaints merited the introduction of stricter controls regarding the sale of such products. But the problem is that the risks are not clearly understood - either in the context of the smoker or the passive smoker. For example, 30 countries have banned advertising of ecigarettes and barred the use of such devices indoors. Britain, meanwhile, has said any device on sale from 2016 onwards must be approved by the same regulatory body that approves pharmaceutical drugs. What's more, television advertising of these products will be permitted in the UK, but the Committee of Advertising Practice says devices must not directly appear on screen - presumably in favour of a vapour trail. The EU has vague plans to limit the ingredients used, in particular nicotine, and control the advertising methods.

 

As more reports on ecigarette regulation come to light, it could be just a matter of time before the policing of such products becomes clearer - and perhaps more stringent. In the meantime, big tobacco will reap the benefit of a fragmented regulatory landscape. British American Tobacco, for example, won regulatory approval in Britain for its new nicotine inhaler product in September. Curiously, it will be sold as a medicinal product.

Laws linked to plain packaging are also escalating in the western economies. This means that packaging for tobacco products cannot display distinctive branding - with only the brand name in a mandated size, font and place included on the pack. This is in addition to health warnings and any other legally required information such as toxic constituents and tax-paid stamps. Laws are already in place in Australia, and Ireland intends to implement new legislation from this year. The issue is also under negotiation in Norway, India, the UK, New Zealand and Turkey. At the end of September, France decided it would introduce some of the world's toughest antismoking legislation, forcing tobacco companies to adopt neutral packaging and restricting the use of electronic cigarettes. It was seen as a particular blow by big tobacco companies which consider France the cultural home of cigarettes and smoking - sacre bleu!

The traditional tobacco market is still estimated to be worth in excess of $700bn (£432bn) annually. The ecigarette and nicotine replacement industry is worth a measly $3bn by comparison. The main problem big tobacco faces with its traditional products is volume decline, which makes it harder to justify ongoing price increases for cartons of cigarettes. However, if one takes into account the onerous tax burden - which often makes up the vast majority of the recommended retail price - it's easier to defend. The Tobacco Manufacturers' Association (TMA) says the tax on tobacco products continues to be a major source of revenue for the UK government, and it's risen year on year since the early 1990s. For 2012-13, it brought in more than £12bn to the Treasury. On a typical pack of 20 premium-brand cigarettes, the total tax burden (including specific excise, ad valorem excise and VAT) often accounts for 77 per cent of the recommended retail price in Britain. On some cheaper brands, it can be over 90 per cent. On average, the tax is equivalent to 16 out of every 20 cigarettes in a packet sold in Britain.

This tax burden is not replicated in other jurisdictions, far less so in emerging markets. So while sales are under pressure in western markets, companies such as British American Tobacco can generate more than half their profits from developing markets. But while sales fare better in these regions, volumes are still a problem overall. For British American Tobacco, rising volumes in Bangladesh, Pakistan and Indonesia have not been enough to offset volume declines in Poland and Russia.

The crisis for traditional tobacco should not be underestimated. Just last week Japan Tobacco International - the maker of Silk Cut - announced plans to close its last manufacturing plant in the UK. It will end production at its facility in Country Antrim, Northern Ireland, and eliminate hundreds of jobs. It's also closing a production plant in Wervik, Belgium, and shutting its German factory in Trier.

 

 

Favourites

Both London-listed tobacco giants are attractive income plays. But our frontrunner has been Imperial Tobacco (IMT) for some time (the shares yield close to 5 per cent). What's more, the Reynolds American (US: RAI)/Lorillard (US: LO) merger is good news for IMT. On joining forces, America's second- and third-largest tobacco companies will sell the Kool, Salem, Winston and Maverick brands, and the next generation Blu ecigarette brand, to the British company. British American Tobacco (BATS) won't be left out of the deal. Previously, it owned 42 per cent of Reynolds and will inject $4.7bn into the newly enlarged entity to maintain its stake.

 

Outsiders

British American Tobacco (BATS) is a yo-yo stock. Towards the end of 2013 the share price plummeted only to stage an impressive recovery this year to its current price of 3,444p. Its income profile is slightly less alluring than that of Imperial Tobacco - the dividend yield is closer to 4 per cent - and the shares are rated on 16 times forward earnings, which suggests that any improved outlook is priced in for now. It suspended its share buy-back programme to fund the new investment in Reynolds, but chief executive Nicandro Durante said the "strong portfolio of brands" at Reynolds' (US: RAI) motivated the decision.