The prime minister’s pledge to increase the smoking age every year – meaning a 14-year-old today will never legally be sold a cigarette – has coincided with a decline in the value of tobacco stocks.
On such time a horizon though, and while BAT and Imperial more than doubled in value from the 2008 crisis to 2017, Philip Morris International Inc (NYSE:PM) has gone nowhere in capital terms – trading volatile sideways as the market prices it for a not-unhelpful 6% yield at $92 currently.
Interestingly, yesterday BAT and Imperial both rose 2% from levels where (according to consensus forecasts) BAT at 2,460p offered a dividend yield of exactly 10% with 1.6 times earnings cover and Imperial near 10% at 1,600p with 2.0 times cover. It’s unclear quite whether such a nice round double-digit per cent coincides with Imperial affirming full-year guidance for its 2023 numbers, to make investors think the risks here are not actually so great as the market is pricing lowly for.
Macro context of health concerns returns
How many times have we been here before with smoking stocks? They can rally off chart lows in the near term, as investors hope to lock in fat yields and gain capital appreciation as price adjusts “better” for risk. Yet smouldering in the background are the health issues.
Politicians – New Zealand and the UK currently leading – have justifiable reasons for cracking down on smoking now public expenditure and healthcare are under the cosh. Is it fair for smokers to indulge their “freedom” and later socialise the extra burden of complex cancer care on the rest of society? The media nowadays runs regular stories about how vaping has become an epidemic among young people - around 11% of UK children from 11 to 16 are estimated to be addicted – and in some situations it’s doing worse damage to lungs than cigarettes. This has superseded the previous story where vaping was said to be “beneficial” because it weaned nicotine addicts off tobacco.
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Is there a parallel with 1990s US state litigation?
Long-time investors in smoking stocks say we have been here before, yet the companies adapted and thrived. US lawsuits, chiefly on health matters, originated in the 1950s then gathered pace in the 1990s, culminating in the 1998 Tobacco Master Settlement Agreement with the four largest US companies – to compensate states for medical costs of caring for people with smoking-related illnesses.
Despite hundreds of billions of dollars exacted, and restrictions on marketing, it did not prevent these companies being a reliable income source for investors. The stocks may have been volatile, albeit without involving long-term capital loss.
Pressure on big tobacco companies 30 years ago seemed quite overwhelming compared with now. But what is different this time is the steady ratchet of outlawing tobacco purchases, which seems potentially more damaging in the long run.
It depends what extent of further countries adopt this measure - if an (effective) tobacco ban is judged better for public finances, and if the benefits of lower healthcare demands outweigh high tax revenues.
Imperial flags broadly a turnaround
After the 30 September financial year-end, Imperial’s guidance remains for revenue growth in low-single digit per cent, with “adjusted operating profit growth to accelerate to the lower end of our mid-single digit range”. Foreign exchange currently contributes a 2% tailwind both to revenue and profit.
Further modest gain in share in the group’s top five markets underlines three consecutive years of improved market share performance following several years of decline. Operationally, it looks like Imperial’s five-year strategy will yield further benefits.
This gives encouragement to investors who believe the companies can navigate challenges ahead.
Stronger pricing continues to help offset relatively higher volume declines against historical averages. “The US, Spain and Australia are expected to show market share growth, more than offsetting declines in Germany and the UK,” the company says. But how sustainable might this approach be if the global economy weakens under elevated interest rates, to affect consumer spending power?
Imperial Brands - financial summary
Year-end 30 Sep
|Turnover (£ million)||27,634||30,247||30,066||31,594||32,562||32,791||32,551|
|Operating margin (%)||8.1||7.5||8.0||7.0||8.4||9.6||8.2|
|Operating profit (£m)||2,229||2,278||2,407||2,197||2731||3,146||2,683|
|Net profit (£m)||631||1,409||1,368||1,010||1,495||2,834||1,570|
|Reported earnings/share (p)||66.0||147||143||106||158||299||165|
|Normalised earnings/share (p)||94.3||178||150||163||187||305||235|
|Operating cashflow/share (p)||330||320||323||337||420||229||334|
|Capital expenditure/share (p)||17.1||23.2||41.2||44.6||47.4||21.1||25.5|
|Free cashflow/share (p)||313||297||282||293||372||208||309|
|Covered by earnings (x)||0.4||0.9||0.8||0.5||1.2||2.2||1.2|
|Return on total capital (%)||9.9||11.3||12.3||10.4||13.7||17.2||13.5|
|Net Debt (£m)||12,664||11,925||11,220||11,348||10,325||8,786||8,405|
|Net assets per share (p)||554||595||605||519||515||524||672|
Source: historic company REFS and company accounts.
While the market appeared to respond well to a proposed further £1.1 billion share buyback “return” in 2024, after £1.0 billion targeted for 2023, I find this somewhat perverse because Imperial (like BAT) carries substantial debt whose cost is starting to gnaw at operating profit now that interest rates have risen. The genuine dividend “return” is strong, so why not reduce debt with spare cash flow?
Management says it intends to maintain its gearing level – expressed as net debt being twice EBITDA and which gets an investment grade, credit rating. Yet end-March net debt had risen close to £10 billion in context of just over £6 billion net assets – of which 274% constitute intangibles. On an adjusted basis, this took 12% of operating profit – not hefty but could rise further if interest rates remain “higher for longer”.
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BAT in broadly similar proposition, but stronger on vaping
BAT’s shares rose in sympathy with Imperial, although any third-quarter update is pending. In the first half to 30 June, revenue rose 4.4% albeit with the benefit of a 1.8% tailwind; adjusted operating profit by 3.6% at constant currency, with this margin edging up 0.4% to 44.3%. So, essential dynamics are similar to Imperial.
BAT does have a relatively stronger “new categories” offering which enjoyed 29% first-half revenue growth and is targeted for profitability in 2024. “However, we do not expect growth to be linear, as levels of investment will align with the phasing of our big innovation platforms,” said the firm.
It is debt-heavy: £38.5 billion net debt last June, relative to £73 billion net assets – of which 168% constitute intangibles. First-half net finance costs of £921 million took nearly 16% of interim operating profit, higher than Imperial. So perhaps interest rate concerns have weighed lately.
Yet both stocks’ 2% rise yesterday, in a weak market, shows investors attuned to circa 10% yields as too-low pricing for the risks. I re-iterate a similar overall “hold” stance as Imperial: further upside potential currently, albeit long-term risks.
British American Tobacco - financial summary
Year-end 31 Dec
|Turnover (£ million)||13,104||14,130||19,564||24,492||25,877||25,776||25,684||27,655|
|Operating margin (%)||34.0||32.2||151||38.2||34.8||38.1||39.8||38.2|
|Operating profit (£m)||4,453||4,554||29,547||9,358||9016||9,820||10,234||10,573|
|Net profit (£m)||4,290||4,648||37,485||6,032||5,704||6,400||6,801||6,666|
|Reported earnings/share (p)||230||249||1,360||260||247||273||289||293|
|Normalised earnings/share (p)||234||239||251||284||316||328||326||307|
|Operating cashflow/share (p)||253||247||261||449||393||426||423||442|
|Capital expenditure/share (p)||32.3||36.1||47.7||41.1||35.6||32.9||32.4||29|
|Free cashflow/share (p)||221||211||213||408||357||394||391||413|
|Covered by earnings (x)||1.5||1.5||13.6||1.3||1.2||1.3||1.3||1.3|
|Return on total capital (%)||19.8||16.3||23.6||7.2||7.4||8.0||8.4||7.8|
|Net Debt (£m)||15,003||17,276||45,649||44,259||42,243||40,088||35,933||39,114|
|Net assets per share (p)||263||439||2,649||2,853||2,786||2,732||2,924||3,371|
Source: historic company REFS and company accounts
Terry Smith has not dumped tobacco
I recall how Imperial used to be one of Fundsmith Equity’s largest holdings, since sold down, yet Philip Morris is at number seven ahead of Visa Inc Class A (NYSE:V). It would appear Smith’s team rates Philip Morris for its international brands, similarly with L'Oreal SA (EURONEXT:OR) at number three. Yet, implicitly, they are also content with the inherent risks of smoking stocks, even if not favouring Imperial or BAT nowadays.
This is amoral analysis; it is your decision whether to invest, not dissimilar to oil & gas where the environmental lobby fumes at more drilling contracts but pragmatists say the transition to “net zero” must be realistic in context of energy demands.
With the UK stocks offering more tantalising yields, I would feel more comfortable holding them than Philip Morris. While BAT is slightly off the pace this morning at around 2,500p, Imperial is up another 1.1% to 1,660p.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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