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FTSE 350: All eyes on tobacco regulation

London's two listed tobacco companies are waiting on results from an investigation into the quantity of nicotine sold in cigarettes in the US
January 25, 2018

The past few years haven’t been easy for tobacco companies. Fewer and fewer cigarettes are sold every year, regulators are getting tougher on the health hazards of nicotine, and governments around the world consider the industry ripe for higher taxation. This has encouraged the two main UK-listed tobacco companies, British American Tobacco (BATS) and Imperial Brands (IMB), to focus their attention on alternative products.

This time last year, our FTSE 350 review on tobacco suggested the US was the land of opportunity for selling both traditional and alternative products. But, in August last year, the US Food and Drug Administration (FDA) announced its intention to cut the amount of nicotine allowed in cigarettes to “non-addictive levels”. The review is focused specifically on traditional cigarettes, since inhaling smoke particles along with nicotine can’t be good for the consumer. Other products that contain nicotine are not set to be subject to any upcoming restrictions. The US is the third-largest cigarette market in the world, so shareholders in Imperial Brands and British American Tobacco could be nervous about potential changes. The companies have 23 per cent and 43 per cent sales exposure to the US, respectively.  

Tighter regulation may make trading in the US more difficult, but recent changes to tax laws could help compensate. British American Tobacco stated that the new US Tax Cuts and Jobs Act would reduce its effective tax rate from 30 per cent to somewhere in the high-20s – something that is expected to deliver a 6 per cent boost to EPS in FY2018. Imperial Brands has less exposure to the US than its rival, but would still feel the benefits of a more favourable tax rate in the year ahead. 

While emerging markets have been a target market for the two companies due to their light-touch approach to rules, investors may want to keep an eye on changing taxes and regulation in these regions in the coming year, too. A 160 per cent levy was introduced on chewing tobacco in India, while Chinese smokers can no longer light up indoors or in some public areas. China accounts for one in every three cigarettes smoked globally, and so both companies will no doubt be wary of any further regulatory changes. 

A tougher stance from regulators to get consumers to give up appears to be working. The number of traditional cigarettes sold by both tobacco giants has continued to fall in recent years. At the most recent set of half-year results British American Tobacco reported a 5.6 per cent fall to 314bn sticks sold, while Imperial Brands stated at the full year that units sold fell 4.1 per cent to 265bn. Yet, although the markets for cigarettes can be challenging, both companies have continued to deliver sales growth at a group level, as well as higher dividends. Imperial Brands shares in particular carry an impressive dividend yield and is on our list of income majors. Partly, this is because of the shift to new electronic products while also encouraging those smoking traditional cigarettes to buy premium, more expensive, brands.

Any optimism from the two tobacco giants now centres on innovation, or what the two companies are doing outside of their traditional brands. One type of product proving a popular alternative is the vaporiser, where users inhale tiny particles of flavoured nicotine. British American Tobacco’s glo vapour product now has a 2.3 per cent market share in Japan and has recently started selling in Canada, Switzerland, South Korea and Russia. It also sells Vuse, another vaping product, in Europe and the US. Imperial Brands has already shelled out £300m on developing next-generation products and recently spent £107m on the acquisition of Nerudia, which makes liquid nicotine for e-cigarettes. It’s aiming to sell these alternative products into 20 different markets by the end of the 2019 financial year, compared with four at the most recent set of results, with new product launches lined up to help stimulate demand.

CompanyPrice (p)Market value (£bn)PE RatioYield (%)1-Year ChangeLast IC view
British American Tobacco5,003114.820.03.59.2Hold, 5,433p, 27 Jul 2017
Imperial Brands3,07329.328.95.6-13.3Buy, 3,162p, 04 Jan 2018