For a period in which many defensive sectors performed well, 2013 proved a tough year for the tobacco sector.
As well as the expectation of rising US interest rates affecting the income attractions of the sector, industry-specific headwinds included concerns over the possible impact of e-cigarettes, fears over the introduction of plain packaging and the impact on earnings of challenging conditions in certain European markets and of the weakness of emerging market currencies.
Headwinds are, of course, nothing new for this sector. As long ago as 1973, BAT Industries (as the company was then known) noted that “it would not be sensible to ignore the strong and growing pressures being brought to bear against the smoking of cigarettes in many parts of the world”. In the 1970s and early 1980s, the tobacco companies reacted to this threat by spending their prodigious cashflows on building a stream of non-tobacco earnings (British American Tobacco, for example, purchased Eagle Star Insurance and owned both Argos and Macy’s department store).
Such acquisitions were necessarily earnings dilutive. The companies’ refocus on tobacco in the late 1980s proved the catalyst for the subsequent spectacular outperformance by the sector. This outperformance was greatly driven by cash returns – the cash that had previously been used for diversification was now being returned to shareholders via dividends and share buybacks – rather than, until more recently, by
a re-rating of the shares.
In the portfolios I manage, I hold the shares of BAT, Imperial Tobacco and Reynolds. The sector’s rehabilitation is such that the ratings of these shares no longer look bargain basement. BAT has a forward price to earnings ratio of 16.3 and yield of 4.2 per cent; back in the 1980s and 1990s the p/e was typically lower than the yield.
But while the sector’s prodigious cashflows are now well known,
I have identified the sector’s ability to grow earnings and therefore grow dividends at a better rate than the market in general expects. There are also still growth opportunities for these companies in emerging markets as consumers are expected to switch to their international branded products.
The scope for improved efficiencies in the business model – as well as enhanced cash conversion of profits – comes from a variety of sources. Declining sales volumes may be a challenge on one front but they allow the ongoing closure of less efficient factories.
The acquisition of inefficient, formerly state-owned domestic companies provides further opportunities because these have cost bases that can be easily cut on integration. Imperial Tobacco, for instance, has flagged the scope for driving out improved efficiencies in working capital and increasing its cash conversion of profits. This metric increased from 63 per cent in 2013 to 78 per cent in 2014 and the company is confident that it has further to rise as it continues to make progress in reducing its working capital.
What is also underestimated by the stockmarket is the potential for the enhanced use of IT to drive down the companies’ cost base.
The manufacture of cigarettes may be relatively low-tech where the rollout of new IT can have little impact but the companies’ highly complex supply chains can see a major benefit.
The big picture is not all about declining volumes and cost-cutting; there remain some growth opportunities for key brands in certain markets. In the US, still low pricing of cigarettes (which can cost as little as $6 [£3.50] a pack in some states) allows scope for price increases while Reynolds’ Camel and Pall Mall brands continue to register strong market share gains.
Imperial Tobacco, meanwhile, has shown that there “is a way through plain packaging” with strongly rising volumes of its JPS brand in Australia. BAT has benefited from focusing on its “global drive brands” Dunhill, Kent, Lucky Strike and Pall Mall.
An increasingly global market – and one where there are no new entrants – should benefit international brands. This in turn allows companies to reduce the costs of the promotion of more domestic-only brands. International air travel, with duty-free sales, along with rising wealth is expected to drive a switch from the consumption of the local brand to these global brands.
Headwinds will prevail for this sector but one advantage of these headwinds is that there are no new entrants to the industry. And I believe that the companies’ combined focus on cost-cutting, cash conversion and cash returns to shareholders continues to make them attractive holdings within my portfolios.
Mark Barnett is head of UK equities and portfolio manager at Invesco Perpetual