FTSE 350 Review: Pivot to tobacco alternatives may not be enough for UK giants

The tobacco industry faces an increasingly challenging regulatory landscape as governments increase taxes on the sector, ban new products, and consider cracking down on traditional sale streams. While cigarette stocks displayed their defensive strengths in 2022 and outperformed the market, ethical and legal headwinds remain at the fore of the tobacco debate despite next-generation product (NGP) sales growth.

In the UK, the Labour Party has trailed the potential phasing out of tobacco sales, as recommended last year by the government-commissioned Khan Review. New Zealand has already implemented a staggered ban. This is, clearly, not a positive development for the tobacco stocks.

The European Commission, meanwhile, wants to slash smoking rates by 2040 so that fewer than 5 per cent of people on the continent use tobacco products, down from a current EU average of 23 per cent. It outlawed flavoured heated tobacco products last November and has proposed tax rises that could double duty on packs of cigarettes in European countries where prices are relatively low. It also wants to make the taxation of NGPs consistent with cigarettes.

Across the Atlantic, US regulators are also getting firmer. The US Food and Drug Administration (FDA) has banned several products from the market. This includes items from ecigarette maker Juul, part-owned by Altria (US:MP), and the body noted sternly that such companies are playing “a disproportionate role in the rise in youth vaping”.

Tobacco merchants are already battling with secular trends such as declining smoking rates. Tobacco use is falling across populations – daily smoking rates fell from an average of 21 per cent in 2009 to 17 per cent in 2019 across OECD countries.

The two London-listed cigarette purveyors, British American Tobacco (BATS) and Imperial Brands (IMB), have responded to all this by focusing on next-generation products (NGPs) such as vapes and oral nicotine. But while growth in this area continues, these sales still make up only a small amount of the overall revenue pie, and governmental action shows that there are still serious concerns about the impact on health and the products' addictive qualities. There are also clear signs that the market doesn’t think NGPs are a panacea for the industry’s ills, with shares in vape-seller Supreme (SUP) down heavily since it joined Aim in 2021.

The London giants have been implementing significant share buyback programmes to drive value. This is a major sector attraction, with environmental, social and governance (ESG) concerns otherwise dissuading many investors. RBC Capital Markets analysts describe buybacks as “the only way to unlock [tobacco] shares 'cheapness'”.

British American Tobacco chief executive Jack Bowles warned in the company’s full-year trading update in December of downtrading in the US market and added that “industry volumes remain under pressure due to ongoing macroeconomic factors and post-Covid normalisation of consumption patterns”. This is something to watch as 2023 proceeds, along with sustainable-investor and regulatory uneasiness, weighed against strong cash flows and attractive valuations.