The purpose of this article is not to make the argument for investing in tobacco according to socially responsible investing (SRI) guidelines. Rather, we demonstrate how tobacco stocks fit the Quality team’s approach to long-term sustainable investing, and are consistent with how we integrate environmental, social and governance (ESG) factors into our philosophy and process.
As long-term active quality investors, we aim to invest in companies with enduring competitive advantages, disciplined capital allocation and a focus on sustainability, which enable them to deliver persistently high or improving cash flows and returns on invested capital. We believe a company’s business model, financial model and capital allocation decisions should be aligned with the long-term interests of shareholders, whilst also balancing the needs and interests of other key stakeholders. Understanding the impact of ESG factors on all stakeholders allows us to determine holistically whether the company’s competitive advantages and profitability are sustainable over the long term.
Tobacco: The quality investment case
Tobacco has proven to be a very defensive industry, remarkable against a backdrop of government intervention, heavy regulation, negative press, and shrinking cigarette volumes.
Pricing power is key to this characteristic. Cigarette volumes peaked in the 1980s and have been in decline since. However, strong pricing power (illustrated in Figure 1), given tobacco’s low elasticity of demand, has outweighed volume declines over the past 30 years. Additionally, taxation models have meant that tobacco profit pools have continued to rise in the face of volume declines. The largely fixed value of excise (with further increases limited, moreover) means any price increases drop to the bottom line. This has resulted in very stable earnings streams, cash flow and dividends from big tobacco companies.
Figure 1: Strong pricing power
Source: BofA ML Global Research, data to 2017.
The US and Japan, which are high volume markets, still have room to absorb further increases, given the relative affordability of a pack of cigarettes in these countries. Figure 2 illustrates this point, whereby Japan and the US have the lowest cigarette prices relative to income (average pack price/ income in US dollars).
Figure 2: Cigarette per pack prices relative to income* (in US$)
Source: BAT, June 2017 presentation. *Income defined as average per pack price/ GDP/capita (100s).
As consumption drops on average by 3% per year, the industry has sought to minimise costs, primarily through consolidation. British American Tobacco (BAT), Phillip Morris International (PMI), Japan Tobacco (JT), Imperial Brands (IMB) and Altria dominate outside China. Effectively an oligopoly, the industry has been able to diversify geographically, focus on brand investment and most importantly, combine operations and improve efficiencies reducing variable costs. Continually taking costs out has resulted in predictable and rising margins, ultimately driving sustainable profit growth. Whilst further consolidation is likely to be harder from here, there still is potential.
Can anything disrupt this oligopoly? Size, scale, distribution and brand power say “no”. Additionally, while tax and regulation have been headwinds, they have also entrenched high barriers to entry and created a very stable environment for big tobacco companies. How?
- As already mentioned, government intervention has been limited through the large tax contribution from excise, approximately US$600bn per annum. Disruption of the oligopoly would therefore threaten the large funding source on which governments have come to rely.
- In addition, adverse regulation has supported the concentrated market dynamic, because small independents lack the deep pockets and resources to comply with every demand, further deepening the oligopoly.
This stability combined with these companies’ capital light nature, has resulted in very stable cash-flow generation over time and sustainably high returns on invested capital (ROIC), making the industry attractive to quality investors. For example, the ROICs of PMI and Altria are currently 3-3.5x higher than that of the market as a whole (35% vs. 9.6%). That is, for the same amount of capital, these businesses are able to generate 3.5x the profits, through superior pricing power.
Although the sustainability of the ROIC and the free cash flow are the most important determinants of long-term returns for an investor, valuation needs to be considered. Tobacco companies have historically traded at slight premiums to the market. However, the recent market rotation and risk-on environment has resulted in consumer staples stocks, including tobacco stocks, derating. The tobacco sector is now cheaper than the market on a price-to-earnings (PE) basis, as illustrated in Figure 3. The industry has not been this cheap relative to the market since the end of the Global Financial Crisis.
Figure 3: Tobacco PE ratio vs. MSCI ACWI
Source: Investec Asset Management, Factset. April 2018. Earnings per share for Altria and British American Tobacco revised down to adjust for one-off impacts of corporate activity in 2016 and 2017 respectively.
Using the valuation argument alone, it is clear that tobacco companies are attractively valued relative to the market. Even on a free cash-flow (FCF) yield basis, tobacco is trading in line with the market. And on a dividend yield basis, tobacco is currently offering double the yield of the market. However, taking the analysis one step further and combining the quality metric, ROIC, the argument for tobacco is further strengthened. The ROIC for tobacco is almost double that of the market, as illustrated in Figure 4. It is a key factor why tobacco commands a position in our quality portfolios.
Figure 4: Valuation relative to Quality
Source: Investec Asset Management, Factset, 30.03.18.
Ensuring long-term tobacco sustainability
Tobacco is arguably changing the fastest of consumer staples, largely thanks to ‘self-disruption’ typified by the rise of new generation products (NGPs)/reduced risk products (RRPs). Tobacco has chosen this route to balance growing nicotine demand and health and regulatory concerns.
The long-term sustainability of tobacco businesses rests on developing more socially acceptable tobacco products, with reduced harm. The businesses will have to focus on minimising the negative externalities associated with their products, their operations and the value chains. As an example, PMI has focused its developments in marketing of products in a responsible way via plain paper packaging and health warnings; good agricultural and labour practices; climate change mitigation; and ensuring that employee wellbeing, diversity, and safety programmes are in place. The range and importance of stakeholders will vary by company, but in all cases these relationships are not just a matter of corporate social responsibility, but a prerequisite for delivering growth and sustainable returns going forward.
As long-term shareholders of tobacco, we understand that the regulator is a key stakeholder in our assessment of a business model. The regulator shapes the landscape for tobacco, and is a key input when determining whether the terminal value of tobacco is indeed zero. The most recent regulatory ‘headwind’ has been the announcement by the Food and Drug Administration (FDA) in the US that it is the intention to regulate all nicotine-providing products (not just cigarettes), and to reduce the overall levels of nicotine in all products. We believe that the FDA’s position does not impact the short-term operational performance of big tobacco as this is a process that is likely to take many years to conclude. The industry has recognised the long-term opportunity of the regulatory changes, responding with research and development, and innovations of a continuum of RRPs. These products are likely to be the growth vector for the industry, sustaining the lifespan of tobacco businesses.
The reduced risk products (RRP) market is growing
Each of the tobacco majors now has at least one form of product in the category of ‘reduced harm’. What are this category’s prospects?
The global retail tobacco market (ex-China) is circa US$550bn. Traditional cigarettes continue to dominate, making up 90% of the market. The remaining 10% of the market is split between cigars, chewing tobacco, loose tobacco and RRPs.
Within RRPs, the tobacco heating products (THPs) category and the vaping category total US$18bn, or 3.2%. This combined market share is smaller than cigars and cigarillos, but BAT expects THPs to achieve compound growth of 44% over the next three years (2017-2020) and vaping 18%, giving a combined growth rate of close to 30%. If these growth figures materialise, these combined categories should double their market share over the next three years, to over 6% of the global tobacco market. Are these growth assumptions reasonable?
The key factor determining the ultimate size of this market will primarily be the pace of substitution by smokers to THPs, given the low rate of new users adopting THPs. Vaping exhibits higher levels of new users, and hence will be key to real growth in the long term.
It is clear that innovation in RRPs by big tobacco should be encouraged by all key stakeholders, especially shareholders, given the growth outlook. But importantly, it is a move in the right direction to reduce the health risks for the world’s 1.1 billion smokers, a step closer in attaining the ultimate vision to live in a smoke-free world. Once there is regulatory clarity, it should entrench and strengthen the sustainability of the tobacco business model.
We believe the terminal value of tobacco is not zero. Tobacco businesses are high-quality, defensive compounders, operating in a stable industry with entrenched barriers to entry. Their financial strength and strong competitive advantages have enabled them to generate and sustain higher levels of profitability than the broader market. Their stable nature and capital light structures have resulted in strong and predictable cash-flow generation. This has enabled them to declare attractive dividends over time, introduce RRPs and address potential loss of market share.
Regulation and disruptions are changing the tobacco world; however, we believe this is an opportunity for the industry. The focus on innovation and RRPs will be the fundamental driver of long-term profitability of tobacco manufacturers. It is a key business model factor we assess when determining the quality of a tobacco company. Furthermore, the strength of their business models and competitive advantages rests on how they choose to prioritise and allocate their resources to mitigate overall negative impacts and create opportunities for wider societal value, incorporating all key stakeholders. This assessment is implicit in our quality philosophy approach.
Currently, the RRP market is a battleground being fought by big tobacco and independents. Regulation is required to provide clarity and clear the path for a roll-out plan of RRPs. In our view, the current valuation accounts for this regulatory uncertainty. But more importantly, we believe the current valuation does not appropriately reflect the positive outlook for tobacco – the growth potential of RRPs and associated reduced health risks and lower tax burdens; the scope for further industry consolidation; and the pricing and cost reduction opportunities.
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