By Siphesihle Zwane and Varshan Maharaj
Of the companies we research, the tobacco industry has some of the best structural fundamentals. Tobacco consumption is relatively price-inelastic, which means that price increases can make up for falls in sales volumes.
Taxes make up a large portion of sale prices. This creates price leverage, causing consumer prices to rise by less than net revenues received by the business when excise rates do not change.
In addition, specific taxes in some countries and efficient distribution make it difficult for new entrants to compete on price, especially since marketing is not allowed in most countries.
Combine all of this with a business that doesn’t need to reinvest a large portion of its earnings, given a simple product and falling volumes, and you get companies that are able to grow while paying out a large portion of their earnings in the form of dividends.
BAT is a good example.
High barriers to entry have historically made it difficult for new entrants to disturb the incumbents, with investors happy to pay up for this, however, the discount to other consumer staples has widened with the risk of disruption from next generation products (NGPs).
To protect attractive cigarette economics, the industry never invested aggressively in new ways to consume nicotine. This changed when Juul, a vapour brand, began to significantly grow in the US by introducing innovative products with flavours and marketing, forcing incumbents to increase their investment in NGPs, a major shift from the stable nature of the industry.
BAT reacted to the disruption by launching three different devices/products. These options looked to pose significantly less harm to the consumer compared to combustible tobacco products, but with untested economics and often deep investment cycles.
Most large market regulators have accepted the principle of harm reduction, differentially taxing NGPs versus cigarettes. While this advantage is unlikely to stay forever, it supports the industry while it builds scale to lower unit costs.
Even if profitability at market maturity is lower than that of the cigarette market, the reduced harm of these products to consumers and those around them will likely mean more sustainable cash flows over the long term, deserving of a higher valuation multiple.
Big Tobacco is encouraging smokers to quit or, if they are unable to do so, to switch to NGPs via various consumer education initiatives. These products are all relatively new and while the current science regarding harm reduction has been positive, we continue to monitor the science to better understand the longer-term impacts.
Extensive global distribution networks, existing customer bases, and available funds to finance the large investment required to reach scale give incumbents an edge in the NGP market. In addition, as the regulation around these products becomes more closely aligned with that of cigarettes, barriers to entry should start to more closely resemble those of the pre-NGP tobacco landscape.
The competitive landscape
BAT is currently targeting £5 billion (R119bn) NGP revenue by 2025, and break-even by 2024, with 50 million NGP consumers by 2030. Further out, they expect at least 50% of group revenues to come from NGPs by 2050. This won’t be easy, as the overall industry also sees the benefits of these new products.
Players with a larger share of their revenues coming from NGPs have better revenue growth and margin prospects, and the market is rewarding them with higher earnings multiples, as shown in Table 1.
The value to trade buyers is also reflected in PMI’s recent acquisition of Swedish Match, which was done on a multiple of 28 times trailing earnings. Swedish Match derived 69% of its net revenue from NGPs at the time of the acquisition.
PMI’s progress is an indication of the upside potential if BAT can successfully execute its NGP strategy.
Risks associated with tobacco investments
The sector comes with some significant risks, the largest of which are regulatory. These risks have not had a large noticeable impact on earnings yet, but have caused the sector to trade on a lower multiple of earnings.
Outsized excise-driven price increases could lead to a large-scale shift to illicit trade, which currently makes up 9% of total volumes and costs governments around $40bn (R738bn) per year in taxes. Big Tobacco is an efficient tax collection and regulation enforcement machine, which is preferable to the industry being controlled by illicit players.
BAT has a high debt burden at 2.9 times Ebitda (earnings before interest, taxes, depreciation and amortisation). This is, however, well protected against the short-term impact of higher interest rates. BAT’s average cost of debt is 4%, 97% is fixed rate and the average maturity is 9.9 years.
The business has paused share buybacks to allocate funds to debt repayment as the outlook for longer-term rates has increased. Inflation also benefits the revenue line, given strong pricing power, with the associated interest rate cost coming over a longer time, given the above-mentioned protection.
The risk of declining volumes is always top of mind. Smoking prevalence is declining, and the population is growing. The net effect is that the number of smokers has remained between 1 billion and 1.1 billion since 1990.
Integrating environmental, social and governance (ESG) factors into our research is intrinsic to our investment philosophy. There are several nuances and complexities, and emerging news headlines and trends have to be examined in the context of each company, and the sector and country within which it operates. A rational approach is key.
A long-term opportunity for patient investors
BAT’s share price has not reflected the fundamental results of the business in recent years, but at a growing 7% GBP dividend yield, shareholders should be well rewarded for their patience.
Siphesihle Zwane, analyst, and Varshan Maharaj, portfolio manager, Allan Gray