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Questor: after a 45pc fall, British American Tobacco is starting to look cheap
Questor share tip: higher taxes and marketing restrictions may finally be biting on tobacco firms but the fears look overblown
Health campaigners will rejoice that 2018 is the year Big Tobacco ran into big trouble.
Fund managers whose portfolios have benefited from bumper returns for decades will be less triumphal. Not since the major cigarette makers conceded two decades ago that smoking causes lung cancer and emphysema, and spent billions to settle legal claims have tobacco firms been more on the back foot.
British American Tobacco, producer of the Lucky Strike and Dunhill brands, has seen its shares collapse by 45pc so far this year. They are now at their lowest level for more than seven years.
It would seem that higher taxation and marketing restrictions are finally taking effect. Yet tobacco is a long way from being stubbed out completely. Last year BAT sold a staggering 686bn cigarettes after volumes fell by 2.6pc, compared with a 3.5pc market decline. Although volumes will continue to fall, there will still be more than a billion smokers in the world by 2025, roughly the same number as today, according to the World Health Organisation.
The bigger worry is that the “next generation” products that are meant to drive top-line growth have encountered some teething troubles. In October, BAT warned that sales from vaping pens and “heat-not-burn” devices – which claim to offer more smoking-like pleasure than vaping but with fewer toxins – would reach £900m this year, not the hoped-for £1bn.
Japan, the most advanced heat-not-burn market, disappointed and there was an e-cigarette product recall in the United States. The big firms are also closely watching vaping start-up Juul, which has become a teen craze with fruit flavours that have attracted the attention of regulators.
That may have prompted the US Food & Drug Administration (FDA) to deliver a curveball last month that suggests a key part of the industry will soon go up in smoke. Its proposed ban on menthol cigarettes – another favourite with young smokers – will hit BAT hardest.
- Questor archive: telegraph.co.uk/questor
One surprising statistic is that 35pc of the US tobacco market is of the minty variety. BAT knows this well, because in 2017 it paid £42bn for RJ Reynolds, which makes Newports, the biggest menthol brand. US menthol cigarettes are estimated to contribute 25pc of group earnings. All of this means it is not an ideal time for the chief executive, Nicandro Durante, to hand over the reins.
Next April, Jack Bowles, the chief operating officer of the international business and 14-year company veteran, takes over as BAT boss. Durante’s exit, announced five days before Bowles was anointed, looked curiously disjointed.
Bowles may find that the menthol problem he inherits doesn’t leave such a nasty taste in the mouth as the market fears. Number crunching from Deutsche Bank suggests a £1.3bn hit to earnings if the ban were imposed at the start of next year. But the bank reckons 60pc of lost menthol sales could be transferred to non-menthol cigarettes.
The FDA has yet to put a date on its proposed ban, which will take several years to enact. Even if BAT eventually loses all menthol sales with no customer transfer to non-menthol, there is still some upside in the shares from here, Deutsche believes.
There is also a balance sheet issue to weigh up. Concerns that BAT is carrying too much debt have got the short-sellers excited. Net borrowings equivalent to a toppy 3.6 times next year’s forecast earnings are a hangover from the Reynolds deal.
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One option to reduce debt would be to sell BAT’s near-30pc stake in ITC, a tobacco-heavy Indian conglomerate with which relations have been strained down the years. The stake is currently worth £11bn. After hosting a recent lunch with BAT’s management, UBS analysts reported in a research note that the company continued to consider the long-term opportunity for the asset but saw no reason to sell. We can cope, the message seems to be.
Of course, investors will decide whether it is appropriate to own tobacco in their portfolio these days. Questor, which last rated BAT shares a hold in August, merely points out that, trading at a little over eight times next year’s forecast earnings, they have begun to look cheap – even with huge disruption ahead. A trading update on Dec 12 may help to lift the gloom.
Questor says: buy
Ticker: BATS
Share price at close: £27.50