Tobacco: profits and growth are hard to stub out

The market thinks regulation and declining usage will hit the sector hard,  and some tobacco giants are now priced at 20-year lows. But the market’s predicted the death of big tobacco before… and been wrong


Siân O'Sullivan

Siân O'Sullivan

Portfolio Director

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Tobacco: the one thing everyone agrees upon is that it’s a highly controversial industry.

Beyond that, views diverge. Some see the sector as in a state of stagnation and decline. Others see it as resilient and dynamic.

In one sense the world’s large tobacco firms have evolved very little: they continue to produce, market and distribute just one product. But these businesses have also proved adaptive, facing and surviving a succession of setbacks.

In 2018, however, the industry faced fresh threats. The rapid growth of new, innovative tobacco-related products resulted in a tough response from regulators, spooking investors and raising questions over the long-term outlook for the sector.

Share prices of the world's biggest tobacco firms fell by as much as 49% in the year, pushing valuations to 20-year lows. One result has been eye-catching dividend yields as high as 8% from a sector which, for many investors, has been a long-term source of income.

This piece examines the challenges to the industry and assesses how it might respond and fare in future. It’s a sector that has proved important – and extremely valuable – to many investors. Will it adapt and survive as it has in the past?

2018: a difficult year for tobacco

Two trends came together in 2018 to produce a shock for the sector.

The popularity of e-cigarettes and other “next generation products” continued to grow, especially among the young - and reached a point where authorities responded with an abrupt clampdown.

Some commentators claim that JUUL, America’s most popular e-cigarette provider (see below), single-handedly prompted the US regulatory shakeup.

JUUL poses a problem in particular because of its clear appeal to younger users, some of whom don’t realise the products contain nicotine.

The Food and Drug Administration’s response was to announce a range of controls whereby the sales of e-cigarettes are restricted. It also committed to an eventual ban on menthol cigarettes - although this will take some years to implement. Again, the problem with menthol is its apparent popularity among the young.

Opponents of menthol cigarettes argue that they increase rates of take-up or “initiation”. By masking some of the unattractive tastes and odours they can also prolong the smoker’s habit, it is claimed. There is also evidence of an (incorrect) perception that menthol cigarettes are less harmful.

The FDA announced that they are in step 3 of a 9 step process to ban the use of menthol cigarettes in the US. The key issue for the FDA is that they have to be able to prove that menthol cigarettes increase the initiation rates of smoking. Canada has already banned menthol cigarettes and the EU will do so by 2020. As with other regulation, the negative consequences for governments are a loss in tax revenue and the risk of increased illicit trade.

Do alternative poducts attract new users? Or do they help existing smokers quit?

Regulators are faced with a conflict, in particular in relation to e-cigarettes.

It is recognised that these products help some older smokers transition to less harmful habits. The FDA’s action was an attempt to steer these products away from younger markets, hence its decision to ban flavours in distribution channels where age is harder to prove (such as corner shops and petrol stations) and permit them to be sold only in specialist “vape stores” where age verification is more stringent.

The FDA also required JUUL to limit its range of flavours and the names used to describe them.

Next generation products – what they are and how they work, and who’s making them

The total “next generation product” (NGP) market was estimated to be worth $12.3bn in 2016, compared to the traditional cigarette market of $680bn – some 55 times larger.

However, the NGP market is forecast to more than double by 2021, whereas traditional tobacco has seen sales volumes decline by 9% from 2012 to 2017 and this trend is set to continue. Against this backdrop it is not surprising companies are investing heavily in NGPs. British America Tobacco, for example, has spent $2.5bn since 2012.

Sometimes called “reduced risk” products, NPGs fall into two categories: e-cigarettes and “heat-not-burn”.

E-cigarettes, or vaping products, are perceived to be considerably less dangerous than traditional cigarettes, and their uptake has been widespread – among both traditional cigarette smokers and non-smokers.

About 60% of UK vapers are smokers and roughly 40% “ex-smokers”. In France as much as 9% of users have never smoked before.

JUUL is a brand of e-cigarette which has enjoyed exponential growth. It has 72% of the US e-cigarette market share. Its success is attributed to the sleek high-tech design of the device, flavours such as “cool cucumber” and “crème brûlée”, and an impressive marketing strategy targeting the millennial generation through mediums such as Instagram and social media influencers.

A 2017 study by the Truth Initiative found that 7% of US teenagers aged 15–17 and 12% of young adults ages 18–24 use JUUL in the US. Although not yet in the dictionary, “juuling” has become a commonly-used verb. Research suggests many users do not recognise that the device contains nicotine.

Percentage of US secondary school students currently using e-cigarettes and other tobacco products

Source:  National Youth Tobacco survey, the Truth Initiative

The second type of product, “heat-not-burn”, involves a device that heats tobacco at a lower temperature than if it was burned.

While e-cigarettes work by vaporising liquid containing nicotine, heat-not-burn devices apply heat to tobacco in leaf form.

Philip Morris claim the process produces 90% less chemicals than traditional cigarettes. It replicates smoking to a greater extent than e-cigarettes - and is generally perceived as more dangerous.

Japan accounts for over 90% of the heat-not-burn market, according to Euromonitor. This is because the liquid used in e-cigarettes is regulated heavily in Japan and heat-not-burn is therefore the preferred NGP.

The leading brand in Japan, iQos (owned by Philip Morris), sold 44 billion units in 2018 and accounts for approximately 16% of total tobacco earnings in Japan. Profit margins are 30-50% higher than with traditional cigarettes, and so it is not surprising that businesses are investing heavily.

Where next for regulation?

The tobacco industry has been taxed heavily for decades. In the UK, 80-90% of the cost of a pack of cigarettes is tax, which makes smoking more costly and less attainable. In the UK alone tobacco consumption generates nearly £12bn in revenue from duties and VAT each year.

It is frequently debated as to whether this adequately compensates for the costs of treating people will smoking-related illness.

In light of the various NGPs on the market, the life of a tobacco regulator has become more complicated. Two main schools of thought have emerged:

The first views NPGs as a complement to traditional tobacco and sees it as encouraging the smoking habit, particularly the young, with the danger that these consumers could easily switch to traditional tobacco. This view would incline toward regulating NPGs in line with traditional tobacco products.

The second view sees NPGs as a favourable substitute to smoking and something which helps committed smokers quit. This view results in more favourable regulation of NPGs.

Because these products are fairly new there is limited social and scientific evidence to form a clear view.

Regulation, for now at least, is country specific. For example, in the UK, Public Health England has said there is no evidence that e-cigarettes increase teen tobacco smoking, but in the US research suggests that the use of e-cigarettes amongst the young encourages consumption of traditional cigarettes. 

What all this means for tobacco giants – and their future revenues

The share prices of tobacco firms fell heavily in 2018 as investors feared that regulatory action in the US would considerably accelerate the decline in sales of traditional cigarettes. Valuation of the tobacco majors is now back at 2008 lows and in some cases, such as British American Tobacco, back at levels last seen in 2000.

We think the market’s reaction is excessive.

In relation to regulatory clampdown, we think at least a portion of menthol users will switch to non-flavoured tobacco or NGPs in the event of a full menthol ban. In addition, the US regulatory process is long and cumbersome and a full ban could be at least 5 years away.

The emerging markets continue to play a significant part in the strategy of the big firms.

There are 77 million smokers in Africa alone, and that number is expected to grow by 40% from 2010 to 2030. Regulation is far less stringent, taxes are lower and therefore overall pricing is lower - giving more room for the tobacco companies to raise prices as a means of revenue growth.

Increased attention will focus upon NGP sales in the coming years as the industry transforms. The tobacco companies have not all taken the same approach to their NGP strategy: Philip Morris has invested heavily in heat-not-burn, Imperial Brands in e-cigarettes and British American Tobacco in a combination of the two.

Challenger-brands such as JUUL pose threats, but these newcomers may eventually become absorbed into one or other of the established firms. Just before Christmas, for example, Altria bought a 35% stake in JUUL for $12.8 billion (implying a valuation for JUUL of $38 billion).

As ever, evolving trends and consumer tastes could have a big impact on the outlook for the big firms - but this is not a new threat.

The regulatory backdrop remains complex and that too will be a key determinant of how the market develops. History tells us that the big companies tend to win against the small in the face of regulation - but 2018 has shown it is a bumpy journey.

Big tobacco, big yields

Source: Reuters

Dividend yields significantly above those of the broader market suggest some investors fear future dividends are not secure. Unless there is a significant shift in the landscape our view is that the dividends are comfortably covered by earnings in the near (three-to-five year) horizon.

Tobacco timeline: a history of disruption, survival – and success

Tobacco first “discovered” by Christopher Columbus in the Bahamas and Cuba. It had long been used across the Americas in religious ceremonies and for medicinal use.

Tobacco smoking, chewing and snuffing becomes a major industry in Europe and its colonies.

Late 1800s and early 1900s
The first machine is built to automate cigarette production. The industry transforms itself through marketing, relying heavily on celebrities to help influence society and take tobacco use from a minority to the majority.

The sector enjoys more than five decades of unchallenged success.

The first scientific evidence linking smoking to lung cancer and other respiratory problems emerges. The tobacco companies respond with attempts to confuse the public and discredit the research with scientific research of their own. Substantial investment is poured into marketing to sway public opinion.

The first surgeon general's report on smoking and health is issued in the US. The debate shifts from the scientific realm to the political.

The industry is successfully sued by several US states who claimed that the tobacco companies deliberately understated the link between smoking and cancer contributing to illness and death. This ends the industry’s 42-year clear clean slate in tobacco litigation.

The WTO received 168 signatures from different countries for the Framework Convention on Tobacco Control. This paved the way for the development of products that help people quit smoking. The first modern e-cigarette was invented in China.

In this 10-year period the tobacco industry wins 59% of all cases brought against it.

The UK introduces the smoking ban in all workplaces and enclosed publics spaces.

Obama signs into law the Family Smoking Prevention and Tobacco Control Act which bans additive flavours to traditional cigarettes with the exception of menthol.

The first modern “heat-not-burn” tobacco product, iQos, is launched by Philip Morris, based on their product Accord which had been released earlier.

JUUL, an independent, privately owned, challenger e-cigarette business is launched.

European and US regulators extend their remit to include e-cigarettes

The Food and Drugs Administration (FDA) in the US launches an attack on nicotine, flavoured cigarettes and menthol, arguably posing the biggest challenge the industry has seen in 70 years.


Siân O'Sullivan

Siân O'Sullivan

Portfolio Director

Siân joined in 2014. She is a Portfolio Manager responsible for managing private client portfolios both on and offshore. She graduated from the University of Bristol with a 1st class BSc (Hons) in Economics and Politics and is a CFA charterholder.

This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. 

Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital unless otherwise stated.