Tobacco lit for slow, steady burn

Restrictions on the sale, advertising and packaging of cigarettes have grown tougher, particularly in recent months. The Food and Drug Administration (FDA) in the US is deciding whether to clamp down on menthol cigarettes because it's claimed they do even more harm. The European Union is one step ahead. It recently voted to ban menthols and outlaw the sale of cigarettes in packs of 10 - thought to be favoured by the young - by 2016. In the UK, 10-packs account for 38 per cent of all cigarettes sold. 'Plain packaging' rules, already used in Australia, are widely anticipated, too. There, cigarette cartons display gruesome images intended to warn that smoking kills. Unsurprisingly, many smokers Down Under now complain that cigarettes don't taste the same. In fact, graphic health warnings on tobacco packaging have been rolled out in 20 countries in the past five years and more are planned.

Smoking in public places has been banned in many countries, too - 32 in the past five years - and several governments restrict tobacco advertising, with a complete ban in 24 countries covering 10 per cent of the global population. Meanwhile, richer nations are spending more money educating youngsters on the dangers of lighting up, while paying for addicts to quit. But stricter regulation is not just unique to wealthier nations. One-third of the world's population is now protected by government measures to limit tobacco use. Take, for example, the Indonesian Health Ministry, which is seeking to ratify the World Health Organization's Framework Convention on Tobacco Control. Should it pass, cigarette regulation and taxes are likely to increase significantly, which could hold back industry growth even further, warn analysts at Nomura.

So, Big Tobacco faces a major headache as governments all over try to strangle its growth. But if this paints a rather bleak picture for the future of tobacco, there are several points worth remembering which continue to make tobacco a good investment. First of all, tobacco consumption is growing globally, despite governments' best efforts to the contrary, according to figures from the WHO. Trends differ geographically - tobacco use is stable or declining in rich countries, but rising among the poor, which now account for 80 per cent of the world's 1bn smokers. Second, most tobacco companies have been able to offset declining volumes by raising prices and cutting costs, generating steady profit growth. This is what allows tobacco companies to pay reliable and generous dividends to income-seeking investors - tobacco shares yield on average more than 4 per cent. This, coupled with the non-cyclical nature of tobacco, makes it a classic defensive play.

And, crucially, tobacco companies have moved quickly into the fast-growing market for electronic cigarettes, which many consider a potential game-changer. Analysts estimate US e-cigarette sales will reach $1bn (£616m) this year and could hit $10bn in five years as smokers make the switch. Here in the UK, e-cigarettes are said to contribute roughly 1 per cent to annual cigarette declines and they're threatening traditional cigarette volumes across Europe, too. It's already boosting sales for many tobacco companies, and undoubtedly a fantastic business model: one product hooks consumers, and the other helps to unhook them - a win-win situation. And the companies that do not have a presence here could suffer serious damage, warns Nomura. "This may be even more so now given that the recent EU draft tobacco directive calls for a ban on advertising, so those companies that have not established a presence during the next couple of years, while advertising is still allowed, will find it even harder to take share."

Imperial Tobacco (IMT) is on track to launch its first e-cigarette product in 2014 through a subsidiary, Fontem Ventures, established specifically to develop non-tobacco products. It recently bought an 'e-vapour' business for $75m, too. US giant Reynolds American (RAI) - the company behind iconic cigarette brands Camel and Kool - already offers electronic cigarettes under the Vuse brand name, as well as nicotine replacement therapy products under the Zonnic label, both of which are lucrative businesses. British American Tobacco (BATS) became the first tobacco seller to enter the UK's e-cigarette market and is developing a range of products. A managing director was appointed earlier this year to specifically oversee these 'next generation' products, and BATS' 'Vype' e-cigarette went live in July. "There has been an emergence of e-cigarette products on the market in many countries around the world, and that trend looks set to continue," the company says. "We place great strategic importance on our work in this area."

Lorillard (US: LO), the third-largest cigarette maker in the US and owner of the Kent brand, recently paid £30m for SkyCig, a UK-based electronic cigarette business, following the $135m acquisition of American peer Blu Ecigs in April last year. The company says the SkyCig acquisition marks its "first major step in building a global e-cigarette business". Lorillard's boss, Murray Kesller, says the goal is for Lorillard to be the "first and best" in the electronic cigarette category globally. And sales have already helped to boost Lorillard's performance. At the half-year stage in June, group net sales were up by $124m, or 4 per cent, of which $106m came from e-cigarettes and the rest from higher prices charged for traditional cigarettes, offsetting a decrease in volumes.

IC VIEW:

Admittedly, tobacco companies face an uphill battle in terms of the harsher regulatory environment and growing awareness of the harm caused by smoking. That said, they're amazingly adept at squeezing out profit growth to offset volume declines and still have a huge customer base that's hooked on their products. Developing markets, where smoking is on the increase, also offer a growing stream of income and there's huge potential in the booming e-cigarette market in Europe and North America, too. Share price growth is unlikely to take your breath away, but dividends are both reliable and rising.