Tobacco Companies Thrive Despite Regulation

The UK Government this week announced plans targeting a further cut in the smoking rate, but the news failed to move tobacco share prices and fund managers back the stocks

Karen Kwok 20 July, 2017 | 9:30AM
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The UK Government this week announced plans targeting a further cut in the smoking rate from 15.5% of the population to 12% or less by 2022.

The UK’s smoking rate was at 20.2% in 2011 when the Tobacco Control Plan launched. The report, produced by the Department of Health, said the Government recognised that it was difficult to quit smoking and would therefore look to deregulate e-cigarettes.

“The evidence is increasingly clear that e-cigarettes are significantly less harmful to health than smoking tobacco,” the report read. “Stopping smoking is hard and many smokers are turning to e-cigarettes to help them in their attempts. In 2016 it was estimated that two million consumers in England had used these products and completely stopped smoking and a further 470,000 were using them as an aid to stop smoking.”

Tobacco Companies Thrive Despite Regulation

Shares in the two UK-listed tobacco mega-stocks British American Tobacco (BATS) and Imperial Brands (IMB) saw little change following the news.

“The whole tobacco industry is used to coping with increasing regulation and taxation for decades. They will continue to grow and these stocks remain a reliable income stream in a low interest rate environment,” said Ben Russon, portfolio manager of the Franklin UK Opportunities fund. The fund has British American Tobacco as its second largest holding, with a 4.7% weighting in the portfolio.

Philip Gorham, senior equity analyst with Morningstar said Imperial Brand’s aim of 10% dividend growth over the medium term is achievable, and he forecasts three years of 10% dividend growth. Gorham expects a significant growth in British American Tobacco’s dividend in the long term as the company continues its exposure in emerging market. 

Fund manager M&G does not think e-cigarettes pose a threat to tobacco firms – in fact, many of them are getting in on the action.

“The diversification of tobacco companies into products believed to cause reduced-harm to consumers should help to provide a more sustainable source of cash flows longer-term,” said M&G. “The high free cash flow generation of the sector and ability to grow dividends, continues to make it attractive in a consumer staples sector where value is hard to find.”

Looking at year to date performance, British American Tobacco has gained 15.9% while Imperial Brands had 1% loss. British American Tobacco is rated two-star by Morningstar analysts, meaning analysts believe the stock is trading above its fair value estimate. Imperial Brands is rated as a four-star undervalued stock by Morningstar analysts.

Revenues of tobacco companies continue to grow significantly despite a tighter control on smoking that leads to a tiny growth on global tobacco volumes. Between 2000 and 2015, global tobacco volumes grew by around 4% while revenues of tobacco companies grew by 98%, according to data from Euromonitor International.

“Those figures outline how the big tobacco companies are crafting a four-pronged strategy that is proving highly effective, especially as they continue to grow their profits and increase the dividends they pay to shareholders,” said Russ Mould, investment director at the online trading platform AJ Bell.

“They continue to focus on their key brands where they can and use these brands to drive demand and particularly price increases for their products.”

UK Funds Continue to Back Tobacco Stocks

There is a growing interest in environmental, social and governance investing, and many ESG-based or ethical funds exclude tobacco stocks from their universes of investable stocks. Research from UBS also shows that MSCI ESG-screened indices did not underperform the broader benchmarks between 2010-2015 in the UK, Europe, Japan or Asia. This proves to investors that their portfolios will not be hurt by an absence of sin stocks.

However, data from Morningstar Direct showed that fund managers in the UK continue to back tobacco firms.

St James’s Place UK High Income and Silver Rated CF Woodford Equity Income, both managed by a star manager Neil Woodford, are funds that own Imperial Brands as one of their top five holdings with 9% weighting in each of the portfolios. Threadneedle UK Equity Income, which is Silver Rated by Morningstar analysts, also has 5% of the fund in Imperial Brands.

Another tobacco stock British American Tobacco makes up 9.2% and 7.3% of the BlackRock UK Focus fund and BlackRock UK Equity fund respectively. St James’s Place UK High income also has 7.9% of its portfolio in British American Tobacco.

E-Cigarettes Remain a Small Share of Profits 

The rising popularity of e-cigarettes is necessarily the reason that helps offset the decline of profits in other cigarette products, Franklin’s Russon argued.

“E-cigarettes are less harmful to their health. They are cheaper and more socially acceptable. However their contribution to companies’ earnings are very small, which are not particularly meaningful for tobacco companies’ current profits. These next generation products are still under development stage, in terms of eventually where these products consumed and packaged,” said Russon.

Morningstar’s Gorham argued that e-cigrettes are more fragmented than cigarettes, which could be detrimental to margins as the category matures.

“It seems likely that conventional tobacco will remain the driving force of the industry profit pool for at least the next decade, but Big Tobacco manufacturers are nevertheless placing their bets on the new categories most likely to win share of smokers,” said Gorham.

Growth in Emerging Markets Offset Declines in the West

Instead, emerging markets remain a key focus with 80% of smokers living in countries with low and middle income, according to the World Health Organisation. The growth in emerging markets is helping to offset declines in the West.

“Any decline of profits and sales are likely to be gradual, with emerging markets still a long way behind the UK and Australia and Ireland in terms of regulation,” said Mould. In the UK, a typical pack of 20 cigarettes the total tax burden of £6.98 accounts for 82% of the recommended retail price of £8.50, according to Tobacco Manufacturers’ Association.

British American Tobacco is one of the strongest emerging markets plays in its peer group, with more than 80% of volume and almost 60% of revenue derived from emerging markets.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
BlackRock UK Equity D Acc8,353.54 GBP-0.80Rating
British American Tobacco PLC3,180.00 GBP0.00Rating
Franklin UK Opportunities A Inc  
Imperial Brands PLC1,762.00 GBP0.00Rating
LF Equity Income C Sterling Acc3.90 GBP0.00
St James’s Place UK Hi Inc Unit Tr L acc  
Temple Bar Ord1,214.00 GBP0.00Rating
Threadneedle UK Eq Inc Rtl Inc GBP0.99 GBP-0.35Rating

About Author

Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk