British American Tobacco (NYSEMKT:BTI), headquartered in London, is the second largest listed tobacco company in the world, by market capitalization. BAT operates in around 180 markets with a portfolio of more than 200 brands; with its four best selling brands being Dunhill, Lucky Strike, Kent and Pall Mall. In addition, BAT owns a 42% stake in Reynolds American (NYSE:RAI), as a result of a merger in 2004. Reynolds American is the second largest tobacco company operating in the United States, with a market share of 26.1%
Results for the first half of 2013
BAT reported that revenue for the first half of 2013 rose 2% over the previous year, and adjusted diluted earnings per share rose 8% to 109.1p (that is, $3.32 per ADR). The company has so far achieved revenue and earnings growth whilst cigarette volumes declined by 3.4%. But, for how long can British American Tobacco continue to grow its earnings whilst volumes are declining?
The market has reacted positively to BAT's 2013 interim results. It is particularly noteworthy that BAT delivered pricing increases and market share growth in many markets. Combined with the fact that BAT had beaten many of its rivals in terms of earnings growth on a constant currencies basis, investors have been slightly more bullish with BAT.
Richard Burrows, Chairman, appeared rather optimistic on future earnings growth, as he comments on the strong interim results:
"Despite fragile economic conditions persisting in some parts of the world, notably Europe, British American Tobacco has delivered another good set of results. The business is performing well and we are confident of another year of good earnings growth."
Many tobacco groups have seen recent earnings hurt by the weakness in emerging market currencies, and the strengthening in the U.S. dollar. BAT is not different, as adjusted diluted earnings per share for the first half of 2013 would have risen by 10% to 111.1p, under constant exchange rates. Over the same period to June 30, 2013, Philip Morris International (NYSE:PM), BAT's bigger competitor, saw its adjusted diluted EPS fall by 0.8% under current exchange rates. But even when currency effects are excluded, adjusted diluted EPS rose by only 4.6%.
Declining cigarette volumes
Source: company results
Source: company results
Big tobacco players are seeing cigarette volumes decline, and BAT is no exception to this. BAT has seen its cigarette volumes steadily decline since 2009; but, despite this, it has managed to continue to grow its revenues and earnings though price increases and market share gains. Nonetheless, the rates at which revenues and earnings are growing have been declining in the most recent years.
For comparison, cigarette volumes for the first half of 2013 had declined more substantially for Philip Morris, which saw volumes fall by 5.1%, compared to a fall of 3.4% experienced by BAT. However, the rise in the excise tax in the Philippines has had a greater impact to Philip Morris's cigarette volumes, where volumes have fallen by 29.7%, for the first half of this year.
Government regulations, such as the introduction of plain packaging in Australia, and the ban on smoking in public places; increases in excise taxes and stronger public awareness of health issues have had some effect in reducing the demand for tobacco. With declining cigarette and tobacco volumes, the main driver for stronger revenues and earnings growth is price increases. Charging higher prices results in higher profit margins; but this can only be sustained by strong branding and softer competition; otherwise, market share may be lost to its competitors.
Are e-cigarettes the solution to declining cigarette volumes?
BAT launched its first electronic cigarette in the UK, the Vype, on Tuesday last week. At first, it would only be offered from its online store, but they may decide to expand distribution to physical retailers. The e-cigarette market is currently very small, with sales of around $600 million in the US. However, there are strong expectations that demand for them will grow quickly; with some analysts suggesting that sales could overtake traditional cigarettes in the next decade.
Big tobacco groups are looking for e-cigarettes to offset decline in traditional cigarette volumes, to maintain the rapid earnings growth they have enjoyed in the past. However, some analysts believe that the increasing prevalence of e-cigarettes would exacerbate the decline in traditional smoking. E-cigarettes are also sold much more cheaply and so do not generate the near 40% profit margins that traditional cigarettes achieve. Increasing regulation, innovation and investment in marketing may help margins in the long run, as large tobacco groups may come to dominate the industry, as they have done so with filtered cigarettes.
It remains unclear what the effect of the introduction of e-cigarettes would have on big tobacco groups, like BAT. But, unless demand for e-cigarettes grows sufficiently quickly enough to offset the increasingly rapid decline in traditional cigarettes; we should expect revenues to begin stalling for even emerging market focused tobacco groups. So far, revenues are still growing slightly for BAT; but the pace at which it has been growing in the past decade appears to have become a thing of the past. Also, expect earnings and dividend growth to slow to the mid-single digit rates for the foreseeable future.
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