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.
Going global
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, Lorillard (LO), which started as a snuff-making business, is facing litigation costs of $116m after one ex-smoker successfully sued the company for giving out free samples to schoolchildren in the 1950s. That case is going to appeal, but it illustrates the challenges in the US market. On the other hand, few other tobacco companies come close to the level of shareholder payouts that the likes of Philip Morris International (PM) and Reynolds American (RAI) make. These companies pay out up to 80 per cent of their available income in returns to shareholders against an average of between 50 and 60 per cent for the UK giants, although this is set to rise, particularly in Imperial Tobacco's case.
■ Declining markets - It is unsurprising that the tobacco companies with the highest earnings-based valuations, Philip Morris and British American Tobacco (BATS), also have the greatest exposure to the developing world. Imperial Tobacco (IMT) and Swedish Match (SWMA), by contrast, are very reliant on a particular set of developed markets to generate profits, with cost-cutting and price rises essential to offset declining volumes. Swedish Match and Japan Tobacco (JAT) have coped well with declining core markets, either through acquisition, or diversification into niche areas, such as cigars and snus. Japan Tobacco is regularly named as a possible buyer for Imperial Tobacco.
| COMPANY | PE 2013 | EPS GROWTH 2013 (%) | DIVIDEND YIELD (%) |
|---|---|---|---|
| Altria | 14.3 | 8 | 5.4 |
| British American Tobacco | 15.0 | 8 | 4.3 |
| Imperial Tobacco | 10.9 | 5 | 5 |
| Japan Tobacco | 12.8 | 30 | 3.1 |
| Philip Morris International | 15.5 | 11 | 4.2 |
| Lorillard | 14.4 | 10 | 5.3 |
| Reynolds American | 13.9 | 6 | 5.8 |
| Swedish Match | 15.9 | 3 | 3.5 |
| GLOBAL AVERAGE: | 12.5 | 10.1 | 4.6 |
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.
IC View:
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.
