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Tobacco shares haven't drawn their last breath
By
Euan Stuart
Dec 12, 2005
At first glance there seem to be more than enough reasons not to invest in the tobacco sector to make even the most bullish nervous. More and more countries are introducing legislation to curb smoking, while, thanks to health concerns, global consumption of cigarettes is shrinking at the rate of half a per cent a year, according to Paul Adams, chief executive of British American Tobacco (BAT). And not only are there fewer smokers, but the BATs of this world can no longer use much advertising to try and make those left buy their brands. Inside the EU, tobacco advertising on TV is prohibited, and new legislation that prohibits tobacco advertisers from using advertisements that can reach beyond that nation’s borders (newspapers sold in more than one country, for example) was approved in 2003 and wassupposed to come into force in July. The good news for tobacco companies is that it didn’t: the crackdown is being undermined by “foot-dragging”, says the FT. Only 12 of the 25 EU member states have provided Brussels with full details of their implementation plans for the advertising ban, and the 2003 cross-border legislation has also been challenged by the German government, who suggests it goes beyond the rules of the EU single market. At the same time, EU efforts to combat smoking continue to be offset by its own farm subsidy regime, which provides e1bn a year to farmers to produce tobacco. On top of this, the EU health commissioner has so far refused to press for a ban on smoking in public places. Note too that many government attempts to cut smoking are easily circumvented. British travellers are still allowed to bring 3,200 cheap cigarettes a time into the UK, so for those who travel even occasionally, UK tobacco taxes mean nothing. A pack of popular cigarettes costs just in £1.36 in Spain, compared to nearly £5 in the UK. And the tobacco companies don’t care where we buy their cigarettes. They’re mainly made in the same factories and make the same kind of margins for their producers either way.
It’s also worth remembering that while many may see the tobacco giants as dinosaurs, they are at least creative ones. Consider the “single”, a new type of self-assembly cigarette that has taken the German market by storm, saysLisa Urquhart in The FT. Once put together, they are practically identical to factory-produced cigarettes. But since they are taxed at the same rate as hand-rolled tobacco, they cost about a third less and have become so popular that sales of them accounted for 5% of group operating profits at Imperial Tobacco last year. The majors have also not been slow to target the growing middle classes of Africa, Russia and China, in their efforts to compensate for the fact that sales growth at home is increasingly hard to come by. BAT, Japan Tobacco and RJ Reynolds (makers of Camel) are already producing cigarettes within China (where less than 5% of the 1.7 trillion cigarettes sold each year are currently made by foreign companies, suggesting huge growth potential). Sixty two per cent of Chinese men and 3.8% of Chinese women smoke. That’s a total of 350 million people and rising. One final reason not to dismiss the tobacco companies is their focus on raising profits by cutting costs. Improvements in technology and distribution systems have trimmed a lot of costs already – BAT just shut its last UK factory for a saving of £40m, for example –- but there should be more to come. Add to that p/e ratios in the low teens, yields around the 4% mark and strong cash flows, and overall it seems there are more reasons to hold shares in the sector than to shun them.
A company that doesn’t “get the credit it deserves from investors”
Tobacco companies can be hugely cash generative, says Peter Klinger in The Times. And their ability to deliver outstanding returns, even in a negative operating environment, has seen the UK’s big three tobacco companies “soar” above the rest of the FTSE 100 since 2000. But that doesn’t mean it’s too late to buy them – they’re still relatively cheap and all offer pretty high yields.
There is no denying the strength of British American Tobacco’s (BAT) first-half performance, says Lex in the FT. Growth of 8% in “like-for-like” profits beat expectations, and underlying growth in cigarette volumes was 2%-6% for its four leading brands. With cost-cutting targets raised and signs of improvement in Canada, France and Italy, “near-term prospects” look good.
BAT shares will probably trade on a price/earnings multiple of 12.8 times after analysts have raised earnings forecasts, which is cheap compared to its rivals, and the stock yields more than 4% to boot. Imperial is a “hidden gem”, says Paul Durman in The Sunday Times. Note that it is one of only five FTSE 100 companies to rate in the RSM Robson Rhodes survey of shares that “don’t get the credit they deserve from investors”. Perhaps they now should. The shares yield 3.8%.
Published in Investment-Advice
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Euan Stuart
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