BATtered & Bruised - update on recent tobacco sector newsflow
Tobacco stocks have come under severe pressure in the last 12-18 months, with the share prices of British American Tobacco (BAT) and Imperial Brands (IMB) falling by around 50% and 20% in the year to date, respectively. From a valuation perspective, short term selling appears overdone and tobacco stocks look good value around current levels.
From a separate viewpoint, we are also acutely conscious that for a number of clients, an investment in tobacco manufacturing and distribution is undesirable given the well-documented impact of smoking on public health. Here, we try to disentangle the reasons for tobacco's recent unpopularity while recognising the sensitive nature of any proposed investment in the sector.
Most of the recent worries relate to the US market, which explains why BAT has been more severely impacted in the period than IMB, given the former's significantly increased exposure to this market following the acquisition of Reynolds American in July 2017. As a result, the US now accounts for 44% of group profits and financial gearing has increased significantly. Below we highlight major investor concerns.
Next Generation Products (primarily vapour in the US)
The US is the largest market for vapour (vape/vaping) usage at the moment and the key point to mention here is that independent operator Juul Labs has captured around 65% of the US market. That leaves BAT, US company Altria and to a lesser extent IMB to fight for the remainder. As the market clearly had factored in meaningful sales and profit growth from this segment (on a 3-5 year view) Juul's emergence has forced a reassessment of previous expectations within the Next Generation Products space. The ability of Juul to swiftly seize market share has also demonstrated that barriers to entry are nowhere near as substantial as previously thought, suggesting the market is reconsidering the longer term value of the vaping businesses.
Juul is perceived to generate its impressive growth largely from the youth/underage consumer segment, a fact not lost on the US Food & Drug Administration (FDA), which duly released a statement on 14 November. This proposed legislation should significantly restrict Juul's ability to reach a large section of its customer base. Specifically, the FDA will ban sales of flavoured e-cigarettes from retail outlets where minors are allowed entry (e.g. convenience stores, petrol stations, etc.). The flavoured variants will still be allowed in specialist tobacco and vape shops with a +18 age restriction.
It is still worth stressing that the FDA is generally supportive of vapour as a safer alternative to cigarettes, which is why menthol and mint flavours – often preferred by adult smokers giving up traditional cigarettes – are exempt from the proposed distribution restrictions.
Proposed ban on menthol cigarettes in the US
In contrast to its stance on menthol vaping products, the FDA has also made it clear that it intends to ban menthol flavouring in combustible cigarettes. There is no explicit timeframe given on this, but the language suggests the FDA will look to have this implemented as a matter of urgency. In practical terms, most commentators seem to think around five years is most realistic at the earliest. It is worth noting that the FDA put forward similar suggestions in 2013 but failed to convert these to legislation as there was insufficient scientific evidence to justify discriminating against menthol vs. traditional tobacco. The tobacco companies are likely to contest this proposal vigorously.
In terms of financial impact from a menthol ban, BAT is much more exposed than IMB. Based on the latest interims (June 2018), the US accounts for 44% of group profit. Within that, menthol accounts for c.50% of sales (c. £4.5bn annualised) and possibly a touch higher in terms of profit. On that basis, it can be assumed that US combustible menthol cigarettes make up c.25% of BAT profit (c. £1bn). Although it would be unreasonable to assume that menthol sales and profits will be lost entirely in the event of a ban, the range of possible outcomes is clearly quite large. The annual profit impact on BAT from a menthol ban is likely to fall in the -2% to -12% range based on reasonable assumptions.
BAT financial leverage
As mentioned above, BAT's acquisition of the 58% of Reynolds American that it did not already own was largely financed by debt, which stretched the group's balance sheet significantly. In the context of a rising interest rate environment and factors such as the potential menthol ban and required investment in Next Generation Products, some investors are beginning to query the sustainability of the dividend. This seems premature based on fundamental financial characteristics such as profitability and cash generation.
Context and Ethical Considerations
An important perspective to bear in mind is that the proportion of sales accounted for by so-called Next Generation tobacco products is still small compared to traditional cigarettes. At present, around 95% of tobacco company sales and profits relate to existing products. The share price moves of 2018 have been largely focused on the other 5%.
As noted above, tobacco is a contentious sector of the market for ethical reasons and we are very sensitive to the fact this will not be an appropriate investment for a number of clients.
Valuations for tobacco companies have fallen over the course of 2018, to the extent that the BAT share price has fallen to levels last seen in 2011. However, tobacco companies have plenty of experience of operating in the litigation spotlight and are unlikely to concede proposed FDA restrictions without a thorough examination of the evidential case. At the same time, a focus on innovation has not been an industry hallmark and emerging competitors have been able to seize market share with relative ease.
How tobacco companies adapt to this new world of competitive challenge while retaining their focus on protection of the existing combustibles franchise is perhaps the key determinant of their future prosperity. We shall continue to monitor this sector closely.
Senior Investment Analyst
18 December 2018