Examining the tobacco sector following proposed changes in US regulation and changing technology.
Sector in focus: Tobacco
It’s easy to think of reasons for not investing in the tobacco sector. Ethical investors understandably refuse to support an industry that has wreaked so much damage on people’s health over many decades. Others may struggle to see the upside as many smokers are giving up thanks to a combination of a growing realisation of the detrimental impacts on health from smoking, to more and more smoking bans around the world.
Fortunately for the industry, declines in tobacco consumption in the UK, mainland Europe and the US have been offset by growth in regions such as the Middle East, Eastern Europe and other emerging economies.
But overall sales of tobacco products have been falling for many years and now the US regulatory body, the FDA, is putting even more pressure on the sector by focusing on reducing levels of nicotine addiction in what is one of the largest tobacco markets in the world.
Shares across the sector fell on that news but it must be said that as dramatic as the plan may sound, it’s worth noting that the details of exactly how it will be implemented may not be clear for some time and it’s likely that any major changes will be phased in gradually. That will, at least, provide some breathing space for companies to adjust their products and strategies.
So how are tobacco companies responding to the situation? Well, mainly in two ways. They’re doing everything they can to make themselves as efficient as possible, reducing costs wherever they can. There’s a natural limit to how far that can go so many have opted to merge with rivals, leading to a process of consolidation in the sector.
That in turn has resulted in the emergence of a small handful of very large multinationals known as the “Big Five”: Philip Morris International (U.S), British American Tobacco (BAT), Japan Tobacco, China Tobacco and Imperial Brands (Imps).
The second major part of the strategy is a big drive to increase sales of the so-called “Next Generation Products”. These encompass a wide variety of different designs but the main ones are e-cigarettes, known as vaping, and “heat not burn” products. Vaping typically involves heating a liquid, which may or may not contain nicotine, to produce vapour whereas heat not burn is done by gently heating a stick of tobacco.
The big tobacco groups are putting a great deal of effort into developing and marketing these, not just to help offset the decline in sales of the traditional tobacco products but also very much to meet demand for less harmful forms of smoking. Currently there are few restrictions on the use of e-cigarettes, but some countries have raised the possibility of banning them in future.
Some of the big groups, like BAT, have already had some success in this area, but recent comments from the largest tobacco group, Philip Morris International, suggest the sector will need to work harder and faster to grow their next generation sales in order to avoid a gap as tobacco volumes fall.
For BAT the news of the FDA plan was particularly significant given its decision last year to take full control of Reynolds American, one of the largest US tobacco groups. Fluctuations in foreign exchange rates can also have a big impact on the major tobacco groups, and that has been a factor for BAT so far in 2018. However, the company said it expects profit growth to be better in the second half of the year, and it is planning a number of next generation product launches in the third quarter.
Imps’ interim results in May went down well with investors as the company reported gains in market share and forecast an improvement in second half trading. The other thing that captured the attention of the market was that the company plans to raise £2bn from asset disposals in order to reduce debt and invest in the business.
Investors need to be especially careful not to become overly obsessed with short term movements in the shares of the big tobacco groups. They are mainly suitable for investors with a medium to long term outlook who are mostly interested in maximising income in their portfolios thanks to the steady nature of their revenues and the amount of cash they generate.
That, along with the huge range of markets they operate in, gives them a great ability to pay dividends and increase those consistently over time. With that in mind factors such as cash flow and dividend cover are much more important than daily changes in the share price. BAT’s dividend yield is a decent 5.1% and it raised its dividend by 15% last year. It clearly retains some appeal for income-seeking investors looking for a low to medium risk portfolio, but it is no better than a hold for us. It pays quarterly dividends but the much smaller Imps does too and it offers an even better 6.5% yield.
Imps, which we see as lower risk, has also made a commitment to increase its dividends by at least 10% a year over the medium term. So far that has been kept for the last eight years. So we prefer the much smaller Imps thanks to the fact that the shares are better value and offer a better dividend yield.
While tobacco shares may not be to everyone’s taste, and the sector clearly faces some challenges, they are certainly worth considering by investors looking for a steady income which is rising.
All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.