The purpose of this viewpoint is not to make an ethical argument for investing in tobacco, according to socially responsible investing (SRI) guidelines. We recognise the impact smoking has on consumer health and society, as well as the different attitudes held by investors towards tobacco. Rather, we aim to demonstrate how investing in tobacco stocks fits the Quality team’s approach to long-term sustainable investing, and is 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 on all stakeholders highlights ESG issues, which are integral to our philosophy and process. This lens 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, historically generating consistently higher returns, stronger growth, and more attractive dividends than the overall market. What is more remarkable is that this has all been achieved against a backdrop of government intervention, heavy regulation, negative press and shrinking cigarette volumes. How has this been possible?
Figure 1 clearly illustrates the key strength of the tobacco business model – pricing power. Cigarette volumes peaked in the 1980s and have been in decline since as smoking has become less socially acceptable and consumer lifestyles have become healthier. Strong pricing power, given tobacco’s low elasticity of demand, has outweighed volume declines over the past 30 years and is the primary factor underpinning revenue growth. However, the attractive pricing economics of tobacco, provided for by taxation models has also 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.
But what about the outlook – can pricing power continue to be a big lever for tobacco companies? We believe it can be. There is still a strong runway for further price increases in two of the considerably largest tobacco markets (by volume of cigarettes sold), the US and Japan, 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).
To continue delivering rising profits to shareholders, where consumption drops on average by 3% a year, the tobacco industry over the years has also turned to cost minimisation, primarily accomplished through industry consolidation. The industry, outside of China, is now dominated by a handful of players – British American Tobacco (BAT), Phillip Morris International (PMI), Japan Tobacco (JT), Imperial Brands (IMB) and Altria being the major five. The oligopolistic nature enables big tobacco to diversify their geographic footprints and earnings streams, focus on brand investment, but most importantly, combine operations and improve efficiencies in their supply chain and distributions, in order to reduce variable cost bases as cigarette volumes shrink. Continually taking costs out has resulted in predictable and rising margins, ultimately driving sustainable profit growth. Do we believe there is still runway for further consolidation? Whilst further consolidation is likely to be harder from here, there still is potential.
Can anything disrupt this oligopoly? Well, the sheer size, scale, brand power and distribution of the big tobacco companies make it very difficult to upset the apple cart. Most importantly, the tobacco industry has always been a highly taxed and regulated industry. Some would argue that these have been the two biggest risk factors or headwinds for the industry. We believe these factors have actually been tailwinds, entrenching high barriers to entry and creating a very stable environment for big tobacco companies. Why is this the case?
- As already mentioned, government intervention has been limited through the large tax contribution from excise. To put it into perspective, the average tax amount levied on a pack of cigarettes often exceeds half the purchase price. It is estimated that, if one were to combine excise, GST/VAT and taxes on operating profits, governments collect close to 77% of the cash value added on the tobacco industry per annum. This amounts to approximately US$600bn. It is clear that governments are the key beneficiaries of the tobacco industry, with tobacco employees, shareholders, debtholders and customers being minority beneficiaries. Disruption of the oligopoly would therefore threaten the large funding source on which governments have come to rely. Protection of the oligopoly therefore appears paramount.
Figure 3: Tobacco cash value collection split, per stakeholder (%)
Source: IAM, internal calculations.
- Adverse regulation has supported the concentrated market dynamic. This statement can be explained using familiar examples. We have seen an ever rising level of regulation of product and packaging – white paper packaging; tighter restrictions on advertising and promotion; and restrictions on where and when smokers can smoke. Health warnings have been introduced, enlarged and made graphic. Every demand made to date has been implemented. Essentially, regulation has deepened the oligopoly barrier to entry as small independents lack the deep pockets and resources to comply with every demand.
The stability of the tobacco market dynamics is attractive for a quality investor. 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). 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%) i.e. 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 4. The industry has not been this cheap relative to the market since the end of the Global Financial Crisis.
Figure 4: Tobacco PE ratio vs. MSCI ACWI
Source: IAM, 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 not 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 5. It is a key factor why tobacco commands a position in our quality portfolios.
Figure 5: Valuation relative to Quality
Source: IAM, Factset, 30 March 2018.
Ensuring long-term tobacco sustainability
Over the past two decades, tobacco businesses have made no secret of the fact that smoking comes with risks – and have continued to create shareholder value despite the industry losing volumes. However, we are clearly entering a new era. Of all the industries in consumer staples, tobacco is probably changing the fastest, with heightened health concerns, new technologies, regulations and disruptions. It is important to highlight that disruption in tobacco is largely ‘self-disruption’, with the rise of new generation products (NGPs)/reduced risk products (RRPs), rather than external disruptive threats that many large staples businesses are facing, such as ecommerce/online penetration and private labels. Why then are tobacco businesses choosing to disrupt their own models? The reality is that the demand for nicotine is growing. This is at odds with mounting health concerns. Tobacco has to address these opposing forces.
We believe the long-term sustainability of tobacco businesses rests on the evolution of their models to find a place in this new more socially acceptable tobacco world. The goal should be to create value and balance the needs of all stakeholders. This means that businesses will have to focus on minimising the negative externalities associated, not just with their products, but also with the operational side of their businesses 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 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 companies, 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. As already mentioned, tobacco has outperformed significantly over time in spite of regulatory headwinds. 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 the big tobacco companies as this is a process that is likely to take many years to conclude. On a longer-term view, however, we believe that these regulatory changes are an opportunity for the tobacco industry. The industry has recognised this, 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’ be it in vaping, nicotine replacement, snus, tobacco heating products (THPs) or e-cigarettes. But how big is this market and how do we expect it to evolve?
The global retail tobacco market (ex-China, which is the single largest market in volume and value, and a state monopoly) is circa (c.) 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 THPs category, is c.US$6.5bn of the retail market, currently led by two big players – PMI with their heat-not-burn (HNB) device and BAT with their Glo device. Vaping is currently a larger share of the RRP market, c.US$11.5bn. However, this is an extremely fragmented market with the big five tobacco companies only making up less than a quarter of the market.
The total combined market share for these two categories therefore amounts to US$18bn, or 3.2%. To put this into perspective, this combined market share is smaller than cigars and cigarillos; however, what is notable is that the growth rates of RRPs are expected to be far superior. 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?
Current evidence suggests that THPs are a ‘switching category’. Only 4% of people using THPs are ex- or non-smokers. This means that 96% of people using THPs are smokers that have switched, or smokers that are dual users. The key factor, therefore, determining the ultimate size of this market will primarily be the pace of substitution by smokers to THPs. We expect this to increase as consumers continue to focus on healthier life choices. Dual usage could also be additive to this market, but this hinges on legislation/regulation of RRPs and the impacts on the overall smoking opportunity.
With regard to vaping, here the evidence suggests that 56% of vapers are actually ex- or non-smokers, meaning that only 44% of users are current smokers. Could one therefore argue that vaping is a substantially additive market for tobacco businesses? This depends on two important factors:
- The relative pace of smokers switching to vaping versus new consumers taking up vaping (or dual usage), i.e. will we see this 44/56 ratio remaining for the foreseeable future? The jury appears to still be out on this.
- And, of the smokers that do switch, will they be spending the same absolute amount on vaping as they did on cigarette sticks?
Why is this last point relevant? Well, key differences between THPs and vaping are nicotine and pricing. THPs are similarly priced to cigarettes with a similar nicotine content, and vaping is somewhat cheaper with lower nicotine levels. This could mean that direct substitution of smokers to vaping, results in reduced overall spend by a typical smoker (versus THPs and cigarettes). However, with demand for nicotine rising, this could be the tailwind required to grow vaping volumes.
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.
Figure 6: IQOS growing market share
Source: PMI, company results.
PMI case study: Investment and innovation to sustain long-term earnings fundamentals
PMI has a very enviable position within global tobacco. It operates in the top 50 markets worldwide (ex-China), taking almost 30% of the global market share (by volume). The company occupies either number one or number two position (by volume) in most of the markets in which it operates. PMI is the most diversified of the big tobacco companies, with half of its profits coming from its top ten markets. The company has the strongest cigarette brand in the world, Marlboro, and PMI continues to take market share. It is very difficult to dispute the strength of its competitive position and the quality of such a large, diversified business.
Most notable is PMI’s recent capital allocation decisions. The business has invested c.US$5bn-US$6bn to date in developing the HNB and vaping categories, giving PMI the first mover advantage in the RRP market. Its HNB device, IQOS (“I quit ordinary smoking”), is industry-leading, and it is estimated that nearly five million consumers around the world have already stopped smoking and switched to IQOS. PMI’s focus has been on Asia, Japan and Korea, but the company has grown its share outside Asia. IQOS is being rolled out in 38 markets globally, and continues to grow market share, as illustrated in Figure 6. This significant technology intellectual property, combined with material roll-out progress to date, are substantial barriers to entry that we believe should sustain PMI’s competitive advantage and ultimately, profitability over the long term.
In the short term, as with any major capital allocation decision, the economics may prove to have a dilutive impact. Substantial investment is required in developing the IQOS product, building market positions and subsidising device sales. This means that PMI’s committed approach to RRP innovation is likely to impact earnings and cash conversion. However, once the pace of roll-out subsides, incremental investment normalises and volumes in IQOS scale, the products will start contributing meaningfully towards absolute profit as smokers start switching. The combination of higher IQOS prices (versus combustible cigarettes) and lower excise per HNB stick, legitimised by better health claims, is appealing for all key stakeholders on a long-term view.
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 battle ground 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.
All information provided is product related, and is not intended to address the circumstances of any particular individual or entity. We are not acting and do not purport to act in any way as an advisor or in a fiduciary capacity. No one should act upon such information without appropriate professional advice after a thorough examination of a particular situation. This is not a recommendation to buy, sell or hold any particular security. Past performance is not necessarily a guide to future performance. Fluctuations or movements in exchange rates may cause the value of underlying international investments to go up or down. This is the copyright of Investec and its contents may not be re-used without Investec’s prior permission. Investec Asset Management (Pty) Ltd (“Investec”) is an authorised financial services provider and a member of the Association for Savings and Investment SA (ASISA). Issued by Investec Asset Management, August 2018.