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Just four tobacco companies control approximately 75% of the world's cigarette market. After Philip Morris International (PM), British American Tobacco (BTI) is the second-largest cigarette company by sales outside China- which is the world's largest cigarette market and closely controlled by the state-owned China National Tobacco Company.

Like their international competitors (including Philip Morris International, Japan Tobacco International (OTCPK:JAPAF) and Swedish Match (OTCPK:SWMAY)) both London-listed British American Tobacco and Imperial Tobacco (OTCPK:ITYBF) have not been immune from tough economies, anti-smoking campaigns, increasing regulation, price wars, increases in excise taxes and higher unemployment rates. These have pushed increasing numbers of smokers to give up smoking altogether or switch to cheaper - and increasingly illicit - cigarettes. All this is unlikely to change in the near future.

Until now, even as tobacco consumption is in decline in much of the developed world, tobacco companies have been able to maintain and increase their operating margins and earnings (and dividends) using local tax changes to announce increases in pack prices, while keeping costs down. This practice may now have come to a (temporary?) halt.

In particular, many Europeans just can no longer afford to purchase the same highly-priced brands and quantities as before due to their economic circumstances. Increasingly, people appear to be stopping smoking altogether or are 'trading-down' with volumes rapidly falling across Europe.

The two tobacco companies that are particularly heavily exposed to European markets are: Imperial Tobacco, which generates more than half of its revenue from Europe; and Japan Tobacco International, which generated some 43% of its 2012 EBITDA from Europe. In contrast, only 22% of British American Tobacco's adjusted profits came from Western Europe last year.

A potentially much bigger threat than affordability - in a governmental effort to reduce smoking rates altogether - is the introduction of plain packaging legislation for cigarettes in Australia. This is now also being considered in the U.K. and elsewhere in Europe. All four big tobacco companies have launched legal challenges against the Australian plain packaging rules, which are due to come into effect by year end. However, if all cases are won by the Australian government, and, subsequently if plain packaging is taken up by other countries, this certainly would hit several of the internationally operating tobacco companies significantly.

Smoking alternatives to the rescue?

Smoking alternatives, such as e-cigarettes, are defined as non-tobacco containing, non-combustible cigarettes which work by vaporising nicotine liquid. They first appeared in the U.S.A. As non-tobacco containing and non-combustible products, they are commonly referred to in the industry as cigarette alternatives,

After an initial early adopter period, e-cigarettes are now gaining increasing acceptance as repeat usage products available through a variety of popular distribution channels, including online, convenience stores and supermarkets (for example, Tesco (OTCPK:TSCDF), the leading supermarket in the U.K, stocks e-cigarettes). The product is now no longer the preserve of specialists.

Established tobacco players have also begun to take notice. This year, in the U.S.A., two tobacco companies have entered the e-cigarette market either by acquisition, (Lorillard (LO) bought Blu for US$135m) or by launching their own e-cigarette brands (Swisher).

In the meantime in the U.K., British American Tobacco set up a "smoking cessation" company called Nicoventures in 2011 in order to develop or license-in modified risk and nicotine delivery products.

According to its licensor and product developer, Kind Consumer, its lead product will be a "pharmaceutically regulated substitute cigarette" not requiring electrical recharging while mimicking smoking 'rituals', including unwrapping a box, taking out a cigarette and 'puffing'.

In an interview with the Financial Times, in September 2012, British American Tobacco's Chief Financial Officer Nicandro Durante claimed that the size of the market for tobacco alternatives could account for as much as 40% of BAT's revenues (which were £15bn [$24.17B] in 2011) in 20 years' time. "It will be sizeable in 20 years' time … it's going to grow," he said.

Mr Durante commented:

I think that, [in] the future, there will be consumers who go for a cigarette [or] a non-combustible product and consumers who go for a nicotine-based product - so this is something we have paid a lot of attention to over last one and a half years.

In the meantime, e-cigarettes currently do not require a pharmaceutical licence and legal classification varies across the world with countries such as the U.S.A. have classified them as tobacco products. It has been mooted that the EU may ban any e-cigarettes that are not registered pharma products, though on an international level, the product still remains largely unregulated.

In conclusion

In the face of increasing restrictions on tobacco consumption in developed markets, and the loss of smoking populations in sizeable value-generating regions such as Western Europe, non-tobacco cigarettes (including e-cigarettes) are likely to come to the rescue of the global operating tobacco players with activities in this emerging market segment.

Should any future legislation clamp down on e-cigarettes which are not registered pharmaceutical products, tobacco companies such as British American Tobacco with their own pharma-approved alternative cigarette-mimicking nicotine delivery devices and with the financial clout to afford the approval process and marketing will be poised to pick up substantial market share.

In the meantime, British American Tobacco's 2012's expected results will do nothing to endanger its dividend payout, with it continuing the group's dividend policy of paying out 65% of earnings as dividends for 2012. While Imperial Tobacco reported dividends up by 11% for its year ending 30 September 2012.

Source: Are Tobacco's Juicy Dividend Increases A Thing Of The Past?

Additional disclosure: Based on our dividend valuation methodology, currently, both British American Tobacco’s as well as Imperial Tobacco’s share prices are trading well above their historical undervalued levels.