Tobacco Stocks: Time To Be Cautious?

by: Dutch Trader

Tobacco market

Growing smoking populations in China and other large-population developing markets, plus the pricing strength of international brands has kept the world tobacco market robust. This is in spite of falling cigarette volumes in many developed markets.

According to Euromonitor International, world tobacco sales were worth some US$740 billion in 2011, about 11% more than in 2010. The global cigarette market increased its value by double digits despite only growing marginally in volume. The achieved global growth was due almost entirely to China which accounted for over 40% of global volume cigarette consumption in 2011. China delivered growth of some 4% which translates to almost 90 billion sticks worth of additional sales - more than all but the 10 largest cigarette markets consumed.

Pricing strength continues

Pricing strength in cigarettes was the driver of global tobacco market robustness and of the financial strength of the industry and its major companies: the average price of a pack of 20 cigarettes in 2011 was $2.4, up from $2.1 in 2010.

Euromonitor International's latest findings suggest that although in most markets and virtually all developed markets price growth, together with other factors, will cause volumes to fall, on a global basis and largely due to smoking population growth in China, the global cigarette market will actually grow in volume 2011-16.

This rise in average prices will enable the value of the global market to increase by some 28% 2011-16 thus ensuring tobacco industry profits to continue to rise, albeit with an increasing proportion coming from today's developing countries as prevalence in developed countries continues to fall.

source: Euromonitor

International flagship brands growing

The four leading international tobacco companies - Philip Morris International (NYSE:PM), British American Tobacco (NYSEMKT:BTI), Japan Tobacco (OTCPK:JAPAF) and Imperial Tobacco (ITYBY.PK) accounted for some 45% of the global market, or around three-quarters of the market outside China. The biggest tobacco business in the world by far is CNTC, the state organisation which controls China's tobacco companies, which supply some 350 million smokers - approximately 40% of the global smoking population.

The leading global cigarettes brands, excluding Chinese brands, were Marlboro, Winston (JT), L&M , Pall Mall (BAT) and Kent (BAT). The leading 20 brands, most of which are global flagship brands owned by the leading international companies, accounted for some 24% by volume of the global cigarette market in 2011, a proportion which has been rising (if the fall in Mild Seven and Altria's Marlboro due to industry decline in the US and the effect of the tsunami in Japan are excluded). Excluding China, the share of the world's top 20 brands in 2011 was just over 40% of volume sales.

Despite the robust tobacco market I think it is time to take money from the table. Since my first article on October 12, 2011 Tobacco Stocks Defensive Play In Uncertain Times and my second article on December 20, 2011 Philip Morris: The Trend Is Your Friend tobacco stocks had a superb performance.

date profit
company ticker 10-12-'11 12-20-'11 9-22-'12 in $ %
Altria Group MO 27.77 29.86 34.06 6.29 22.65
Philip Morris Int. PM 66.31 76.70 92.14 25.83 38.95
British American Tobacco BTI 86.44 93.08 104.80 18.36 21.24

Solid earnings growth and strong cash generation ability made these stocks a safe haven investment, especially in the recent high-risk environment.

However, recent news flow in the global tobacco industry is negative and more bad news in the coming months could affect the whole industry.

Plain Packaging law

Australia is going to implement the Plain Packaging law as of 1 December 2012 as the first country in the world. Other countries/regions such as the UK, New Zealand, France, India and the EU could follow suit in the coming months. In addition, Russia, the world's number 2 cigarette market by volume, is planning to impose a Public Place Smoking ban at the beginning of 2013. Although neither the Plain Packaging laws nor the Public Place Smoking ban is expected to have meaningful impact on the tobacco stocks in the near term, the long-term effect is hard to gauge.

Although the tobacco industry is doing everything it can to oppose the Plain Packaging law, it's likely to spread around the world:

  • New Zealand has agreed in principle to implement PP based on the Australian model.

  • The UK government intends to schedule PP within the next six months.

  • According media reports, the French government will formally propose PP in the next few weeks.

  • The EU also considers banning logos on cigarette packs as part of an upcoming review of its law ("Tobacco Products Directive") to deter smoking. EU may introduce more stringent rules on packaging as well as extend/stricter legislation to newer tobacco related products.

  • Australia's push for PP has inspired India to consider similar laws, to reduce tobacco consumption.

  • Russia is discussing a public place smoking ban. To be implemented early 2013.

Under the PP law, tobacco products must be sold in plain packages without branding. The plain packages will also carry (dramatic) graphic health warnings.

Tobacco companies challenged the laws in the Australian High Court, claiming the PP rules were unconstitutional because they effectively extinguished their intellectual property rights. The court ruling - the PP laws are not in violation of the Australian constitution - deals a blow to global tobacco companies.

As mentioned the PP case had been closely watched by other countries including the UK, New Zealand, Norway, Canada and India, who are considering similar measures to help fight smoking.

However, the PP laws still face a number of challenges under global trade rules. Two higher-potential defences are already under way:

  1. legal proceedings between governments under the World Trade Organisation (WTO). The governments of tobacco-growing countries such as Cuba, Ukraine, Honduras and Dominican Republic have formally objected to the WTO claiming that Australian PP laws are in violation of WTO trade agreements.
  2. Philip Morris International contends that Australian PP legislation violates Australia's Bilateral Investment Treaty (NYSE:BIT) with Hong Kong.

The WTO and BIT decisions could take a long time, normally 2-3 years.

Final Note

The global tobacco industry has got used to ever-tightening regulatory measures including smoking restrictions/bans, retail display bans, health warnings on cigarette packs and consistently rising excise tax rates. Despite a highly unfavourable regulation framework, tobacco companies have managed to push earnings higher and tobacco stocks have generally outperformed the broader market thanks to their stable growth, strong cash flow and high dividend yields.

Caution is to be considered before investing in the tobacco industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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