The current state of global markets is far from desirable. With investors ducking for cover as inflation numbers continue to ravage equity markets, the only sectors in the green this year seem to be the old economy stocks that are plentiful in number on the FTSE100.
Tobacco is back in vogue. The major cigarette manufacturers in the UK and internationally are vastly outperforming the market YTD, led by the UK’s own British American Tobacco LON:BATS up 28% since January, with Imperial Brands LON:IMB and the US maker of Marlboro, Altria NYSE:MO following closely with gains of 11%.
There are good reasons for investors to flock towards the purveyors of cigarettes during tough times; their products are inherently addictive, securing robust demand even as spending across other products falls off. This also enables these companies to raise prices ahead of inflation to protect profit margins and when it comes to supply chain woes, you could say that cigarettes are fairly simple products to supply, avoiding some of the constraints seen in industries with overly complex supply chains.
Imperial Brands sees revenue growth
Recent results from industry leaders suggest positive trading. Imperial Brands, the maker of JPS cigarettes and Backwoods cigars released interim results on the 17th of May. Years of poor performance have plagued the company, which resulted in the replacement of CEO Alison Cooper with Stefan Bomhard in 2020. After 18 months of working towards a turnaround strategy, the latest results show positive signs of progress.
Despite the global pressures, and persistent volume decline in their core product (cigarettes), Imperial posted 0.3% growth in revenues over the interim period. The market was pleased with Imperial’s return to growth in reduced risk product categories, which were up 8.7% and the improved profitability of the group, spurred on by reduced losses in its next generation product category. Owing to positive levels of free cash flow, Imperial managed to pay down £1.2bn of debt during the period, resulting in a more comfortable position of 2.4x net debt to EBITDA, paving the way to return cash to shareholders.
British American Tobacco looks upbeat
The UK’s largest tobacco company BAT released an AGM trading statement in late April. BAT struck a highly confident tone on the pace of current trading and the company’s ability to hit its ambitious RRP (reduced risk product) targets.
During the update, BAT brought to light the fact that it now has 12% of global revenues derived from reduced risk products, up from 4% in 2017.Turning to our 2022 outlook, I am pleased to say that the business continues to perform well in the context of a challenging macro backdrop, as we are building on our strong momentum from 2021, a pivotal year in our transformation journey.
Accordingly, we continue to expect full year constant currency Group revenue growth of 2% to 4% and mid-single figure constant currency adjusted diluted EPS growth, with growth second-half weighted.
We continue to be highly cash generative and expect to deliver cumulative free cashflow of around £40 billion pre dividends over the next five years.
BAT Chairman Luc Jobin
Whilst BAT may have some way to go yet to convert smokers to less harmful products, it noted that in some frontier markets such as the UK, Japan and Sweden, over 40% of revenues are derived from reduced risk products, a sign that BAT’s next generation ambitions could be achievable.
There is no denying that one can find better levels of revenue growth elsewhere in the stock market, however, underlying profitability at the two British firms generates a healthy (and well covered) dividend yield of 8% for Imperial and 7% for BAT, when we add in the intention for both companies to continue to return excess cash through share buybacks, this sets the scene for quite attractive returns given the wider market backdrop.
So what about regulatory scrutiny from the FDA?
In late April this year, the FDA released new statements with the intention to pursue a menthol cigarette ban in the US. This regulatory action would have a significant effect on BAT, which fetches approximately a quarter of profits from US menthol brands such as Newports, a brand BAT acquired with the purchase of R.J Reynolds in 2017. UK peer Imperial would be less exposed to such an impact with only a minimal contribution from menthol products.
Despite renewed scrutiny from the FDA, investors should keep a cool head. The FDA has been attempting to regulate menthol tobacco products since 2010, the first order on the FDA’s agenda since the FDA center for tobacco products was formed in 2009. Alas even after a high profile push for a ban in 2017, led by FDA commissioner Scott Gottlieb, the committee has failed to reach any agreement.
Tobacco regulation in the US has been challenging to implement for so many years due to the balance of stakeholders and the controversial nature of much regulation. Unlike the UK or other markets in Europe, many US states generate a significant amount of income and employment through the production of tobacco products in addition to the excise duty consumers pay at point of purchase. Menthol regulation is also a tricky topic seeing as it is the flavour of choice for African Americans, with some 85% of Black American smokers opting for menthol flavours. Any such regulatory action could therefore create undue implications for the African American community.
The complex issues at hand have led BAT to issue a statement within their AGM update regarding the menthol ban, below
Regarding the FDA’s upcoming response to the menthol Citizen Petition on regulatory product standards in the U.S., it is clear that any such regulation would be highly complex and could take many years to define and implement.
The tobacco sector has been through tough times compared to the wider market over the last few years. The global economic picture looks to be weakening, however, the tobacco companies have improved their balance sheets and remain highly profitable, cash generative entities. Valuations remain highly attractive for the UK’s Imperial and BAT. Now could be a good moment to look closer at these companies.
