All good things must come to an end, goes an old idiom. Investors in big tobacco groups are finding this out the hard way as the reality of a multitude of daunting challenges hits home.
The share prices of big tobacco groups began nosediving in June last year. The price in sterling of the world’s largest tobacco group by revenue, London Stock exchange-listed British American Tobacco (BAT), has plunged 35%, with a similar fall on the JSE, where it has a secondary listing.
The share price of BAT’s closest rival, New York Stock Exchange-listed Philip Morris International (PMI), has also dropped 35%.
This marks a major reversal of the bull run big tobacco groups enjoyed in the wake of the 2007/2008 equity market collapse. Investors who climbed aboard what were perceived to be safe-haven, noncyclical stocks in 2009 went on to be hugely rewarded later.
At its best BAT’s share price had risen almost 200% from its 2009 low. Its rise on the JSE was an even more spectacular 390%, thanks to a weakening rand. BAT’s share price had gained 260% before peaking.
BAT ousted PMI as the world’s largest listed tobacco company in July 2017 when it acquired the remaining 57.8% of Reynolds American it did not already own. The US$49.4bn deal was the largest ever in the tobacco industry’s history, and in a full year will boost BAT’s revenue excluding excise duties to about $33bn.
Gaining full control of Reynolds American marked BAT’s re-entry into the $94bn/year-revenue US market after more than a decade’s absence. Reynolds American’s brands are spearheaded by Camel, Kent, Newport and Pall Mall and complement BAT’s major brands, which include Dunhill, Lucky Strike, Rothmans, Benson & Hedges and Peter Stuyvesant.
Reynolds American brought with it a 34.7% share of the US market. This places BAT second behind Altria subsidiary Philip Morris USA, which has a 50.7% market share. Its Marlboro brand accounts for 43.3% of this.
PMI, with an annual revenue of $28bn (excluding excise duties), was fully unbundled by Altria in March 2008, and operates in 180 markets excluding the US. Its leading brands include Marlboro (outside the US), Chesterfield, Parliament, Lark and L&M.
Selling a highly addictive product into a market which — according to Euromonitor — spans 20.4% of the world’s adults and is worth $685bn/year, would appear to be a licence to print money. This has been the case in the past; but it is showing notable signs of changing.
The first sign appeared as long ago as the 1970s, when cigarette sales in major developed economies began declining. In the US, for example, sales of cigarettes, or sticks, as they are known in the industry, have all but halved since 1981, falling from 630bn to 263bn in 2016.
Big tobacco companies compensated for this ongoing decline in sales in developed economies by turning their marketing attention to emerging markets in Africa, Asia and Latin America. It bought them time: the consumption of sticks rose from 4.45 trillion in 1980 to 5.884 trillion in 2009, according to research firm Statista.
But sales levels in 2009 appear to have been a peak that is unlikely to be seen again. Stick sales have since been in decline. They fell by 3% in 2016 and by 3.5% in 2017, according to BAT.
Big tobacco also finds itself under growing attack by legislators bent on slashing cigarette consumption. Leading the charge is Scott Gottlieb, commissioner of the US Food & Drug Administration (FDA) since May 2017.
The main thrust of Gottlieb’s strategy is to render cigarettes largely nonaddictive through a drastic reduction of their nicotine content.
Gottlieb wasted no time in getting his strategy going, launching his first attack on the US tobacco industry in a speech last July.
"Tobacco use remains the leading cause of preventable disease and death in the US," he said. "But much has changed in the landscape of tobacco product regulation and the FDA’s ability to address this public health crisis."
The FDA’s statute was amended in 2016 to give it far greater authority to regulate tobacco and other nicotine products.
Backing his assault on the tobacco industry with damning statistics, Gottlieb continued: "The [US] death toll from cigarette smoking is 480,000/year while direct health care and lost productivity costs total nearly $300bn/year."
It is not so much nicotine — the key to the addictiveness of cigarettes — which is under attack. Gottlieb’s main concern is the 7,000 other "incredibly toxic" chemicals in cigarette smoke.
No doubt a big concern to tobacco groups and investors is the question: if the FDA gets its way, will other countries follow its lead?
Responding to the threat, big tobacco groups such as BAT and PMI are pulling out all the stops to grow their footprint in the electronic cigarette (e-cigarette) market. BAT, for example, has, together with Reynolds American, spent $2.5bn on the development of alternatives to conventional cigarettes since 2012.
BAT is starting to make headway, having generated revenue of £397m from e-cigarettes in 2017, and wants to raise this to £1bn in 2018 and £5bn in 2022.
E-cigarettes fall into two categories. The first entails heating a liquid containing nicotine to an inhalable vapour in devices referred to as vapes. The second category is heat-but-not-burn (HBNB) devices in which tobacco is heated to 350°C, a temperature at which the nicotine vapour is emitted.
PMI and BAT have developed both types of devices, but they’ll be hoping HBNB devices become more popular with smokers. Barriers to entry into the vape segment are low while HBNB devices are far more complex, making them more attractive to big tobacco groups, says Cobus Cilliers of 36One Asset Management.
The vaping segment is already highly fragmented. In the Chinese city of Shenzhen alone there are more than 600 vape producers.
PMI, which has spent $3bn to develop e-cigarettes, has so far made the best progress with HBNB devices with its IQOS offering, having made strong headway particularly in Japan, where it ended 2017 with a 16% share of the tobacco market.
But things did not go PMI’s way in the first quarter of 2018, with IQOS sales growth falling well below its guidance level and less than half the sales achieved in the fourth quarter of 2017. Quite simply, IQOS has found a big following among younger smokers, but those aged over 50 are not following suit.
News of PMI’s quarter-one setback sent its share price plummeting 14% in one day, its biggest one-day fall since 2007/2008. BAT was also affected; its share price fell 4.8%.
In another setback the FDA’s advisory committee has rejected PMI’s claim that the IQOS causes fewer tobacco-related diseases than conventional cigarettes.
Overall, there seems to be good reason for the drop in tobacco groups’ share prices over the past 10 months. But everything has a fair price.
Cilliers believes BAT’s share price fall has taken it below fair value. "I am bullish on BAT," he says. "It is trading on a low forward p:e of about 12, pays a good dividend [5% yield] and is a big cash generator."
While Cilliers makes a strong case, the negative market sentiment towards big tobacco groups calls for caution.
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