InvestmentsFeb 24 2014

Tobacco: Acting against society but thriving?

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We believe that companies doing good for society make better long-term investments. The response I often get is: ‘Well, if that’s true, why have tobacco companies done so well?’

This piece of research is our detailed answer. We cannot refute the fact that tobacco shares have performed well over the past decade, but we do have real concerns about their ability to carry on doing so.

What has changed? Principally the Framework Convention on Tobacco Control; a treaty which covers 90 per cent of the world population, and whose aim is to accelerate the decline in tobacco consumption. Throw in e-cigarrettes, greater awareness of health impacts and some really aggressive actions by governments globally; and there are definite signs that declines in smoking rates will be much more rapid than the industry would have us believe.

Smoking is proven to be bad for your health. Here we look at why owning tobacco shares may also be bad for your wealth.

Our Approach

Our Sustainable Future (SF) approach is based on the belief that companies which improve our prosperity and welfare will be more profitable and more resilient.

Yet how come tobacco companies, whose product reduces overall prosperity and welfare, have done so well in the last decade? And will this continue?

The possible answers are:

1. We are wrong, and companies acting against society can do well indefinitely

2. We are right, but these things can take time

3. Addictive products like tobacco are exceptions to the rule, which is generally right.

4. Society benefits from smoking and so it will continue indefinitely

We would never invest in tobacco companies for the SF funds, but it has often been cited as a challenge to our SF proposition, so it is important that we can answer the challenge. Also British American Tobacco (BAT) and Imperial Tobacco Group (IMP) make up approximately 5 per cent of the UK index(1) so the question does also have a bearing on relative performance.

Here we examine the tobacco industry and explore three possible trends for tobacco consumption, modelling their implications on the value of tobacco companies.

Tobacco and Smoking: So how bad is it for you?

Tobacco use is the leading cause of preventable death. It kills 6m people prematurely every year and causes hundreds of billions of dollars of economic damage worldwide annually. If current trends continue, then 8m will die early each year by 2030 (WHO Report on the Global Tobacco Epidemic 2011). For context, World War 1 killed 8.5m servicemen.

As a smoker, the question is not whether smoking will kill you, but how. Most common is cardiovascular disease (heart disease or stroke) at 43 per cent, rather than lung cancer at 28 per cent. Female smokers are more at risk, especially if taking the contraceptive pill, and the worst impact is on babies from mothers who smoke.

So pretty bad.

Are governments Acting?

Yes, since the 50s taxation, regulation, and education have been put in place to reduce the prevalence of smoking in developed countries. Now this has gone global with the Framework Convention on Tobacco Control (2005). The stated intention of the signatories to the FCTC is ‘to protect present and future generations from the devastating health, social, environmental and economic consequences of tobacco consumption and exposure to tobacco smoke’.

The treaty covers 90 per cent of the world’s population (Indonesia being the major exception) and signatories have to implement measures to reduce the harm from tobacco. These include: protection from tobacco smoke – bans on smoking in public spaces, education, bans on sales to minors, health warnings on packages (65 per cent of signatories have implemented measures in these areas). And two thirds of signatories have banned advertising and sponsorship.

So there does seem to be a strong, coordinated desire to accelerate the reduction in tobacco use.

Paradoxically, as a consequence of tobacco taxation, smoking has become a revenue generator for many governments – in the UK £10bn pa vs £2.7bn costs to NHS from smoking(2) – so perhaps they don’t want everyone to stop smoking just yet.

Have any been successful?

The UK is one of the leaders in tobacco control and has been able to reduce the proportion of smokers considerably (in 1948, 82 per cent of men smoked and 41 per cent of women).

Prevalence of cigarette smoking by sex in Great Britain, 1974 to 2010

Source: General Lifestyle Survey, Office for National Statistics

Source: Action on Smoking and Health, 2013

This decline in smoking is mirrored in many countries with progressive legislation, including emerging markets, so the measures do appear to be working and the Framework Convention Alliance for Tobacco Control (FCTC) is likely to accelerate their introduction globally.

Where next?

Graphic packaging is being brought in globally and this may lead to a step change in the rate of decline of smoking, and is being keenly fought by the industry which has brought two legal challenges, the first of which has been defeated. But this could lead to a step change in smoking prevalence.

However, thus far the number of smokers and tobacco consumption is not declining as population growth offsets the decline in the proportion smoking. From 1997 to 2008 global ex China cigarette volumes were flat at 3.6 trillion. The last three years have seen a 2.5 per cent decline per annum(3).

The shape of the industry today

The global tobacco industry produces around 5.5 trillion cigarettes a year(4).

The biggest single market is China, where the industry is state-owned, with some 350m smokers who account for more than 40 per cent of the global total(5).

Four international tobacco companies - British American Tobacco, Imperial Tobacco, Japan Tobacco and Phillip Morris International - account for some 45 per cent of the global market, or around three quarters of the market outside China.

Tobacco companies’ global market share(6)

British American Tobacco: 13 per cent

Imperial Tobacco: 5 per cent

Japan Tobacco International: 10 per cent

Philip Morris International: 15 per cent

Others (including Philip Morris USA and our associate companies in the USA and India): 15 per cent

The industry line in the face of all this regulation is to claim that their marketing is solely about gaining market share rather than turning non-smokers into smokers.

Action on Smoking and Health (ASH) and others believe this to be a whopping big lie, and in fact the industry is doing all it can in marketing and lobbying to reduce the rate of decline of smoking in developed markets, while encouraging take up in Asia and low smoking markets like Africa. They are especially focused on persuading women to take up the habit.

The industry has also done extremely well in pushing up prices (obscured by the rises in tax on cigarettes) and in cutting costs. Therefore thus far sales and margins have expanded in spite of falling volumes in developed markets.

How to value the tobacco companies

In spite of the apparent headwinds to growth, the sector has done well over the past ten years – British American Tobacco (BATS) have grown 16 per cent per annum for over a decade. And what is more, analysts expect this to carry on with only 5 per cent of analysts saying they are overvalued. (Bloomberg April 2013)

Indeed tobacco companies now trade on similar valuation multiples to food and brewing companies. Given the latter do not face such strong regulatory pressures this seems too optimistic.

A better way is to look at the fundamental value using a DCF model, and to explore the implications of difference scenarios:

1 Stable numbers for next three years, 4 per cent growth until 2023; and then no growth from 2023 onwards

2 Moderate decline: lower growth out to 2023, and then declining revenues as FCTC takes effect globally

3 Rapid decline: strict regulations are rolled out globally and revenue declines start to take effect after 2017, tobacco all but disappears by 2050.

We did this for British American Tobacco only, but the results are applicable to all cigarette manufacturers.

The current share price of BATS is £35.

Stable – Implies a price of £34.75 i.e. where we are now

Moderate decline – Implies £27.42. 23 per cent downside

Rapid decline – Implies £14.25. 60 per cent downside

Conclusion

To own British American Tobacco or any of the other tobacco companies, you need to believe that the Framework Convention Alliance for Tobacco Control (FCTC) will have little impact and that the rest of the world will follow a very slow fall in the rates of smoking.

We believe there are real risks to this scenario. The FCTC shares the lessons learned by governments in the campaign to end smoking and covers 90 per cent of the world population. We would expect much more rapid control and decline in tobacco volumes as a result.

A more extreme possibility is that the Australian example is followed, leading to a much more rapid decline. In this case investors in tobacco companies would suffer even more severe losses.

In short: society is acting against tobacco companies and they will see their earnings decline. We are currently in a sweet spot where tobacco companies are growing. This will not last, and investors who extrapolate this growth are likely to see severe losses.

Examples of stocks are provided for general information only to demonstrate our investment philosophy. This article is the view of the Investment Manager and cannot be guaranteed, it is for information purposes only.

References

1 Bloomberg, 2013

2 Action on Smoking and Health 2013 Factsheet

3 BofAML

4 BAT: http://www.bat.com/group/sites/uk__3mnfen.nsf/vwPagesWebLive/DO6Z2EUD

5 ibid

6 Credit Suisse 2011

Risk warnings

This article is not intended as an investment recommendation and should not be treated as such. Instead it is intended as an example summary of the work we do looking at longer term changes we anticipate happening in the market which we analyse to inform our investment decisions. This analysis forms only part of what is considered in making an investment decision.

The value of investments and any income from them can fall as well as rise. Capital is at risk and investors may not get back the amount originally invested.

Funds which undertake ethical screening to meet their investment aims are unable to invest in certain sectors and companies. Our exclusion of some areas of the market (on ESG grounds) may result in periods of under-performance with respect to relevant benchmarks. For instance if tobacco stocks were enjoying extremely strong returns we would not be able to participate in their gains.

Alliance Trust Investments does not endorse or recommend any products, investments or services mentioned in articles provided by external parties. The views and opinions are those of the individual as at the date of publication and do not state or reflect those of Alliance Trust Investments