Investment & Strategy

Tobacco: still smoking!

In spite of decades’ worth of scientific and medical evidence about the dangers of smoking (lung cancer, respiratory disorders, cardiovascular diseases…), over a billion people continue to smoke worldwide. There has been a general push of higher-income countries authorities towards lower consumption in recent years. However, the World Health Organization and the National Cancer Institute estimate that the number of smoking adults increased by ~4% since the turn of the century. Efforts from higher-income countries to reduce the number of smokers are likely to be more than offset by increased tobacco use in middle- and low-income markets, which have the potential for economic and demographic growth. While the share of smoking adults globally should fall below 20% by 2025, the number of smoking adults is expected to rise by another ~6%.

According to market research company Euromonitor International, in 2015, ~5.5 trn cigarettes were consumed (or ~USD 700 bn) for an industry worth ~USD 770 bn when including other tobacco products. After hitting a plateau in consumption in 2008-12 (~5.8 trn cigarettes per year); Euromonitor International anticipates cigarette volumes to decline further (2015-20E -5%). Retail prices, on the other hand, should rise steadily leading to an ~37.3% increase of the market value to ~USD 960 bn in 2020.

The Chinese tobacco market represents ~45% of the global market in volume and ~33% in retail value. The world leading cigarette market is covered by a single player, state-owned China National Tobacco Company (CNTC) serving ~300 mn Chinese smokers. A game changer for the tobacco industry would be for CNTC – by far the world’s largest tobacco manufacturer – to adopt an aggressive international strategy. In such scenario non-Chinese tobacco companies would have to cope with another competitor eager to gain market share. This would also create opportunities to access the gigantic Chinese market.

The tobacco market is now highly concentrated with a large number of mergers and acquisitions operated over the past twenty years (average EV/EBITDA multiple of ~12.0x). Philip Morris International (PMI, 15% global market share), British American Tobacco (BAT, 13%), Japan Tobacco (JT, 9%) and Imperial Brands (IB, 5%) dominate the market outside China and the US. In the US, Altria (MO, 2%) which spun off PMI in 2008, holds a 51% market share. Reynolds American , the second player with a 34% market share, was recently acquired by BAT, valuing it at 16.9x EBITDA. We believe that after this merger other players are weighing their options. Investors are certainly drawing up various scenarios.

With growing regulatory pressure against cigarettes, tobacco companies seek alternatives to maintain nicotine addiction through other products. Global sales of electronic alternatives to cigarettes (e-cigarettes, tank systems, heat-not-burn) have been growing fast, increasing more than eight-fold between 2010 and 2015 (CAGR ~52%), according to data from Euromonitor International. However, this fast growing industry only represents a mere 1% of global tobacco sales (USD 8.0 bn in 2015 according to Euromonitor) and many hurdles remain before it becomes mainstream.

The tobacco industry has a strong track record in managing litigations, pricing strategies (governments are determining the affordability of cigarettes through taxes), branding strategies (the strict regulatory framework may lead to a preference for established brands) and costs. Despite such challenging environment, the tobacco industry remains very profitable (5-year average gross, EBITDA and EBIT margin of resp. 47%, 32% and 29%), with elevated cash generation (5-year average FCF margin of 16%). It boasts solid returns (5-year average ROE and ROCE of resp. 58% and 24%) while benefiting from sound financial structures (5-year average Net Debt/EBITDA of 1.4x). Unfortunately the sector exhibits high multiples (FY18E P/E and EV/EBITDA of resp. 19.0x and 14.0x) despite attractive dividend yields (3.8% for FY18E).

In our view, the risk-reward balance looks favourable for British American Tobacco and Japan Tobacco. Both companies offer top-line growth potential, can cut costs further and are reasonably priced.


Kristof De Graeve

Equity Expert

Data & recommendations as of 10 April, 2017 close

This document is an objective and independent explanation of the content of the recommendation and cannot be considered as adapted to a person or based on the analysis of the situation of a person.