Has tobacco run out of puff?

There has been a lot of comment on how flat the share prices of tobacco companies have been since the start of the year (see chart below). Admittedly, markets have been volatile, but that would usually presage a spike in the price of tobacco shares as investors look for a safe haven. That hasn't happened this time and many sector watchers are starting to ask why.

There are two major problems for tobacco investors to consider. Firstly, the tobacco industry faces a renewed round of regulation as more governments decide whether to legislate branded packaging out of existence. Secondly, wilting consumer confidence in many big markets has already proved to be a constraint on the price rises that have kept profits ticking up. It is the threat of slowing profit growth that is key to understanding why tobacco stocks are underperforming. In particular, the re-rating we have seen has been driven by the simple equation that profits growth has been consistently double that of the market's rate of growth over the past decade. That, together with a dividend payout that was double the average for the rest of the market in terms of net income, and you can see why tobacco shares have done well.

The return that shareholders receive in the medium term will depend on two factors: whether regulatory changes impact profits and whether dividend growth continues ahead of earnings, which might make current ratings unsustainable in the long run.

Regulatory woes

The arguments over packaging have rumbled on since Australia last year took the decision to sell all cigarettes in less-than-fetching olive green packets. That case is currently snarled up in the Australian courts, but the UK has floated a similar idea for cigarette packaging in this country - an idea that Imperial Tobacco's chief executive, Alison Cooper, branded "anti-business". The main arguments rage over the implications for international copyright treaties and are probably best left to constitutional lawyers. However, it is also undeniably true that branded packaging is now one of the few ways that cigarette companies can advertise their goods, at least in the developed world, and upholding brand rights is particularly important for companies with a large presence in developed markets where volumes of cigarette sales are in decline.

Dividend support

When it comes to assessing the prospects for the UK's tobacco giants, the packaging debate is a common problem, but the relevance to future prospects is debatable. What is interesting is that the past few months have seen an emerging divide between Imperial Tobacco and BAT as investment propositions. It is true that the buy case for both firms still rests on dividend growth, but this is based on an expectation among investors that the ratio of payout is sustainable in the medium term, which has meant a static running dividend yield of just over 4 per cent.

However, we could be entering an environment, as Imperial Tobacco has indicated, where profits will grow much more slowly than dividends and where payout ratios could continue to rise to levels that may ultimately prove difficult to support - perhaps to more than 80 per cent of net income. The focus on rising dividends also suggests that large-scale takeovers, in what is already a highly consolidated sector, appear to be off the agenda - there is regular talk on slow news days of Imperial and BAT merging their operations, but such a move would run into many regulatory hurdles and has never amounted to more than idle speculation.

Consumers' fragile confidence

Aside from the technical factors underpinning share prices, a lot still depends on the state of the global economy. Astute pricing policies, combined with keeping up with smokers trading down to bargain products such as rolling tobacco, has kept tobacco companies ahead of the recession and the decline in sales volumes. However, consumer confidence is not especially robust at the moment, with consumers feeling squeezed even in markets that are still experiencing growth. For example, consumers in Russia are still buying premium brands in a market where 40 per cent of all adults smoke, while in the big growth market of Indonesia consumer confidence has been falling all year, according to Bloomberg research. That adds up to a mixed picture for the industry in the year to come, which will focus greater interest than usual on the interim reporting season in August.