Vaping has been touted in recent years as a ‘healthier’ alternative to smoking traditional cigarettes, and is often used as a method to give up or cut back on smoking. The products heat nicotine, flavourings and other chemicals into a water vapour that is inhaled, allowing the user to satisfy their nicotine craving without inhaling the burnt by-products of a cigarette. Nicotine itself is not particularly healthy – it increases adrenaline and raises blood pressure, increasing the likelihood that the user could have a heart attack – but vaping has still been perceived as a better method of delivery than a normal cigarette.
However, the perception of vaping as a preferable alternative to smoking is now changing amid concerns over health risks and younger users. Some countries, US states and/or cities have banned or limited sales of vape-related products. US vaping brand Juul revealed on 25 September that its chief executive was stepping down, replaced by KC Crosthwaite – formerly chief growth officer at tobacco group Altria (US:MO), which took a 35 per cent stake in Juul for $12.8bn last December. Mr Crosthwaite said: “I have long believed in a future where adult smokers overwhelmingly choose alternative products like JUUL”, but “today that future is at risk due to unacceptable levels of youth usage and eroding public confidence in our industry”. He noted the need to work with regulators, policymakers and stakeholders.
We also learnt on 25 September that Altria and tobacco peer Philip Morris International (US:PM) had ended merger discussions.
On this side of the pond, changing views around vaping present a problem for the long-term strategy currently employed by the UK’s listed tobacco companies: Imperial Brands (IMB) and British American Tobacco (BATS). Both have experienced a steady decline in the volume of traditional cigarettes sold in recent years, and both have been investing heavily in alternative products such as vapour with the hope that these will compensate for this decline over the long term.
Imperial Brands and BATS have had to scale back expectations regarding sales growth of alternative products. They also have a substantial amount of debt to be serviced. If these products cannot keep cash flowing, then both companies may have to rethink their generous dividend policies.
The not-so-healthy alternative
Vaping is a relatively new phenomenon, and the long-term impact on the health of users is not fully understood. But signs are beginning to emerge that the vaporised molecules have a damaging effect on people’s lungs. The US’s Centers for Disease Control and Prevention (CDC) has identified an outbreak of lung injuries associated with e-cigarette use, with around 805 lung injury cases reported from 46 states and one US territory. So far, 12 deaths have been confirmed across 10 states.
Younger customers appear to be the most keen users of e-cigarettes. Nearly two-thirds of the 771 patients analysed by the CDC were between the ages of 18 and 34 years old, with just over a fifth of patients between 18 and 21. The legal age for buying e-cigarettes is 18, but 16 per cent of the patients in the study were below this age.
The specific chemical exposures causing the lung injuries associated with the use of e-cigarettes is still unknown. So far, there has been no single product or substance linked to all the lung injury cases, but there’s a suggestion that tetrahydrocannabinol (THC), the psychoactive component of the marijuana plant, has played a role in a number of lung injury cases. There is also a suggestion that this may be related to the vitamin E acetate content in THC products. One analyst thought that the proportion of illnesses related to THC could be higher. Since marijuana is not legal in all states, some patients may not have admitted to use – and some younger users may have kept quiet with a parent in the room.
Regardless of the cause, any indication of health implications increases the likelihood of the Food and Drug Administration (FDA) getting tougher on vapour regulations. BATS and Imperial Brands have already had to contend with the FDA’s plans to ban menthol cigarettes, and with reducing the amount of nicotine that can be allowed in traditional cigarettes to non-addictive levels.
Going up in smoke
In light of these health concerns, the CDC has recommended that consumers refrain from e-cigarette use. Naturally, this is an issue for both BATS and Imperial Brands, which sell their vaping products in the US. And it could negatively affect the perception of these products for users in other markets.
Shares in Imperial Brands tumbled after the company warned on 26 September that the US market for next-generation products (NGPs) has “deteriorated considerably over the last quarter with increased regulatory uncertainty”. As a result, Imperial has experienced a “marked slowdown” in the growth of vapour products in recent weeks, with a rising number of wholesalers and retailers choosing not to order more products or not to allow the promotion of vaping products. This “challenging” NGP market in the US, along with difficulties in Africa, Asia and Australasia, meant that group net revenue for the year to September 2019 is now expected to grow at around 2 per cent, with EPS expected to be flat at constant currencies. The NGP business is expected to see a 50 per cent increase in net revenue this year, below expectations.
Meanwhile, BATS continues to invest in its portfolio of new products, including vapour, tobacco heating products and oral tobacco. Indeed, in order to do so, it is reorganising its management structure – thereby achieving cost savings. It’s planning to cut 2,300 roles globally by January 2020, with a fifth of senior roles to be affected. Chief executive Jack Bowles, who took up the role just five months before this change was announced in September, called this part of his goal to “oversee a step change in new category growth”, and reiterated the group target of generating £5bn of revenue from new category products by the 2023-24 financial year.
But, in the past, BATS has scaled back its lofty revenue targets for new categories. The £5bn target was originally supposed to be for 2022, and the new categories revenue target for 2018 was revised down from £1bn to £900m – narrowly beating this at £901m. During the first half of the current financial year sales from new category products came in towards the bottom end of the guided 30-50 per cent range. It’s hoped that this will improve in the second half to around the middle of the guided range thanks to enhanced product launches.
Debt and dividends
Many investors will hold Imperial Brands and BATS for income. Both have rather generous dividend policies, with yields that put them on our annual list of Income Majors. But there are concerns among some analysts about whether these payments are sustainable over the long term, if growth from alternative products such as vapour cannot keep up with the ongoing decline in the volume of cigarettes sold. During the first half of the current financial year, Imperial Brands reported a 6.9 per cent decline in cigarettes sold to 115bn stick equivalents, while BATS saw volumes fall 3.7 per cent to 332bn sticks.
In July, Imperial Brands announced that it would scrap its previous payout policy to increase the dividend by 10 per cent annually following the 2019 financial year, in favour of a “progressive” policy thereafter, taking into account the performance of the underlying business. The dividend will continue to increase, but possibly at a slower rate than before. This change was made as part of a wider review of Imperial’s capital allocation arrangements, with a £200m share buyback also announced. The company also reiterated plans to continue investing in NGP growth, both organically and via acquisition.
BATS’ new chief executive Mr Bowles has not yet given any indication that the company’s dividend policy of paying out at least 65 per cent of group earnings is under threat, but cost-cutting measures have led some analysts to wonder if such a move is not far off, as the company tries to strike a balance between investing in new products, paying dividends and servicing debt. At the most recent set of half-year results net debt increased from £45.7bn to £46.4bn, due in part to the recognition of lease liabilities under new accounting rules, with an increase in interest paid from £786m to £846m. Free cash flow contracted by 55 per cent to £1.23bn, and after paying £2.28bn in dividends, BATS reported an outflow of £1.05bn, compared with a £611m inflow during the same period in 2018.
Imperial Brands also has its own debt to consider, albeit to a lesser extent than BATS. Although net debt increased from £13bn to £13.4bn during the first half of the current financial year, the company’s cost of debt reduced by 0.2 percentage points to 3.5 per cent, thanks to a higher proportion of debt denominated in euros, with a lower interest charge. This reduction in debt servicing costs resulted in a 1.8p increase in EPS to 113p at constant currency. Interest cover also increased from 7.7 times cash profits to 8.6 times. But the amount Imperial Brands paid in interest at £309m pales in comparison to the £1.25bn paid out as dividends.
Granted, cigarettes still make up the bulk of profits generated by both companies, and are higher-margin than products such as vapour. Both outsource parts of the production of vapour products to a third party, and have relied on promotions to encourage consumers to give the product a try.
One analyst reckons that any weakness in public perception of vapour might not be such a bad thing for the tobacco giants. The perception that vaping is a less harmful alternative to smoking is likely to have contributed to the decline in the number of cigarettes sold. If consumers feel that vaping is equally bad or worse for them than smoking, then some may switch back to cigarettes. The analyst believes that for those addicted to nicotine, it’s a question of smoking or vaping, not smoking or quitting. Since cigarettes are higher-margin than vapour, consumers switching back to cigarettes would be beneficial to the industry.