The tobacco industry is going smoke-free - how to profit from it

Tobacco is one of the world’s most divisive sectors. Ever since the first link between smoking and cancer was established in 1950, the companies that produce and sell cigarettes have been under pressure. The pressure intensified in the mid-1950s when the first lawsuits were filed against the US tobacco industry . Over the next 40 years, a steady stream of litigation worked its way through the courts.

Tobacco companies successfully defended their position until the mid-1990s, when more than 40 US states started litigation against the industry. The battles ended with the Tobacco Master Settlement Agreement (MSA) , agreed on 23 November 1998, between the four largest US tobacco companies ( Philip Morris , R. J. Reynolds, Brown & Williamson and Lorillard) and the attorney generals of 46 states.

The 25-year settlement forced tobacco companies to pay $246 billion to state governments. At the end of this year, companies will have paid $165 billion of the total, with the leading players handing out $5.8 billion this year. However, this settlement only relates to the US. Other countries have levied more bills on the sector. In 2015, a Canadian court ordered three tobacco firms to pay C$15.5 billion (£8.7 billion), the largest award for damages in the country’s history. (None of this has yet been paid.)

There is no denying that tobacco firms have a terrible reputation and products with strong, irrefutable links to terminal diseases. Still, despite this reputation and vast legal bills, smokers continue to smoke, and the industry’s main players are still cash machines. If humans were rational beings, the tobacco industry wouldn’t exist. But it does. According to the World Health Organisation (WHO) , the number of smokers worldwide has declined by 20% since 2004.

A marked decline in tobacco consumption

While the agency’s findings show that one in five adults worldwide is consuming tobacco – a significant decrease from one in three in 2000 – the world’s population has increased by a third. So the overall number of people smoking has declined by less than the headline figures suggest. In some regions, the number of smokers has increased, even though the percentage of people smoking has fallen. Once again, this is purely a result of population growth and immigration .

If there is one place that showcases the conflicting sides of the tobacco argument more than anywhere else, it’s New Zealand. In 2022 the country passed pioneering legislation that introduced a steadily rising smoking age to stop those born after January 2009 from ever being able to buy cigarettes legally.

The country trumpeted the changes as the dawn of a new age of better public health outcomes, which could save billions in healthcare spending and revitalise the health of younger generations. But the new coalition government repealed the law before it was due to come into force this July, after deciding it was not worth forgoing the tax revenue. The money has been used to fund other tax cuts .

Despite the detrimental impact on health and cost to the economy , governments have been reluctant to stamp out smoking because it is such a money-spinner. It’s difficult to claim that consumers are not aware of the risks of smoking and, so, the argument goes, if they want to smoke they should be able to, but they should have to pay sin taxes.

However, over the past five years, there has been a seismic shift in the industry’s direction. Tobacco companies have realised there is no future in cigarettes, but there is a future in nicotine. And today there’s a range of different ways to deliver nicotine into the body, most of which are less harmful than smoking . Some, like Philip Morris, are actually trying to kill off their legacy products in favour of so-called reduced-risk products.

This trend is playing out across the traditional “sin” industries. Tobacco firms are reinventing themselves with less harmful alternatives and alcohol companies are reinventing themselves with lower-alcohol products. Alcohol suppliers are also going upmarket, prioritising quality over quantity, a move driven by consumers. The trend towards healthier alternatives extends beyond alcohol and tobacco.

Consumers are moving away from unhealthy fast food and paying more for healthier, protein-rich alternatives. For example, in the first quarter of 2024, McDonald’s first-quarter same-store sales grew by 2%. Sales at Chipotle , which is “cultivating a better world by serving responsibly sourced, classically cooked, real food with wholesome ingredients without artificial colours, flavours or preservatives”, grew by 14% to $2.7 billion.

Elsewhere, start-up Olipop, which touts its soda as a healthier alternative to sugary drinks such as Coca-Cola and Pepsi , has seen sales explode from less than $1 million in 2019 to an estimated $500 million for 2024. The soda is low in sugar and made with ingredients that include plant fibre and prebiotics.

This article isn’t about the ethics of investing in the tobacco industry. Instead, this feature is a close look at a sector that is both reinventing itself and returning vast sums of capital to shareholders – so much so that in at least one case, a company is going to retire all of its outstanding shares within the next decade.

The reinvention of Big Tobacco

Tobacco stocks have hardly shot the lights out with returns over the past decade. Over the last 10 years, shares in British American Tobacco (LSE: BATS) have returned 2.4% per annum, including dividends ; Imperial Brands (LSE: IMB) has returned 2.9%; Philip Morris (NYSE: PM) 5.9%; Altria (NYSE: MO) 6.1% and Japan Tobacco (Tokyo: 2914) 4.8%. These companies have all underperformed their respective index benchmarks, although they have kept pace with cash and inflation .

Except in the case of Japan Tobacco, it has been a case of multiple compression. Shares in British American used to command a mid-teens price/earnings (p/e) ratio . Today, it’s trading on a p/e of seven. Philip Morris used to command a multiple in the low 20s; now it’s in the high teens.

Multiples have fallen as investors have shifted away from the sector for two reasons. The rise of the economic and social governance (ESG) movement has driven capital away from perceived sin sectors. Meanwhile, tobacco firms’ growth prospects have dimmed. Management teams have tried to deal with the latter with some disastrous initiatives, such as Altria’s deal to acquire a stake in e-cigarette and vape firm Juul, which incinerated $13 billion of shareholders’ cash. Rather than show investors the company had a plan for future growth, it did the opposite. No other company has made such a catastrophic error, although other firms have incurred plenty of criticism.

Take BAT’s decision to focus on debt repayment over the past two years rather than shareholders’ returns (buybacks) when the stock was trading at some of the lowest levels in over a decade. This seemed to be driven by management’s belief that it had made an error in buying Reynolds American in 2017 for $49 billion – the company announced a $31.5 billion write-down of US brands at the end of 2023 and has barely mentioned the deal for the past few years.

Although the tie-up lumbered the buyer with a pile of debt, it has not been a disaster. It is estimated that BAT is generating more than $8 billion a year in extra profit from its US operations. Investment bank Panmure Gordon thinks the total cash generated from the deal since closing has been in the region of £24 billion, covering 75% of the cost of group dividends during the period.

Elsewhere, Imperial Brands sold its premium cigar business for £1.1 billion in 2020, despite forecasts suggesting the global cigar market could grow at a double-digit annual rate between 2020 and 2030 as the subsector piggybacks on the growth of the global luxury industry . Then, in 2022, Philip Morris won a $16 billion battle for Swedish Match as part of its ambition to become a global champion of smoke-free tobacco products. The deal lumbered the group with a lot of debt and deflected management’s attention when it should have been focusing on the growth of the overall business.

Over the past five years, tobacco companies have tried and largely failed to get investors interested in the sector again. Billion-dollar deals and plans to exit the smoking side of the business have hardly galvanised investors into action. So why is now a good time to look at the sector? It all comes down to these companies’ efforts to focus on a smoke-free world.

Is the future smoke-free?

What do these companies mean when they say they are aiming for a smoke-free world? Ultimately, it is the delivery of nicotine into the body via different routes, including products such as snus and chewing nicotine pouches, as well as e-cigarettes in various forms. The other, slightly controversial form of smoke-free product is heated tobacco devices. Heated tobacco products heat real tobacco instead of burning it, and companies argue that because they don’t burn it, these products are smoke-free – producing a nicotine-containing aerosol that is fundamentally different from cigarette smoke.

The market for these products has exploded over the past five years, and in 2023 it reached the tipping point. In 2023, smoke-free sales accounted for 37% of Philip Morris’s total full-year revenues. Sales of its flagship IQOS heated-tobacco device overtook sales of Marlboro for the first time in the final quarter of 2023.

Getting to the bottom of how profitable these smoke-free products are is not easy. Most companies do not break out the figures. However, Altria has started to make the data available and the firm’s numbers provide a good insight into what the future holds for the sector. Altria’s portfolio includes the US Smokeless Tobacco Company and NJOY – the latter acquired in June 2023 and currently selling the only pod-based e-vapour product approved by regulators in the US – along with a range of heated tobacco products. Based on numbers compiled by analysts at Panmure Gordon, this smokeless business has the potential to generate $3 billion a year in annual sales by 2026.

That would be equal to 17% of the projected group net revenue and up 20% from 2023, compared with flat revenue over the period for the smokable business. As the smokeless division scales up, Panmure expects the operating profit margin to climb to just under 70% by 2026, compared with 76.9% for smokable. These products are only marginally less profitable than traditional cigarettes.

As smokeless products are also less of a health risk than traditional cigarettes, the legal risks to these businesses are also significantly reduced. That’s the opportunity here. The transition away from cigarettes to other forms of nicotine delivery is just getting started, and there is huge scope for growth in the years ahead.

Should you invest in smoke-free products?

Now could be the perfect time to jump on board this trend. For the past five years, the future of smokeless products has been uncertain, both from a regulatory and a corporate perspective. All of the big tobacco players have been investing heavily, with little or no reward. That’s starting to change. These companies have mostly got past the major start-up costs associated with developing and distributing new products.

Philip Morris, for example, has spent more than $10 billion developing its range of smokeless and reduced-risk products. There have also been heavy marketing costs associated with the products as companies have tried to communicate the benefits to consumers of switching away from cigarettes.

Growth has also been held back by a proliferation of smaller companies that have tried to muscle in on the larger players. Juul was the best example. At its peak, Juul was valued at $38 billion as investors rushed to buy into the company’s success. It claimed it could take on the big players and become the world’s most important vape manufacturer. The scale of the challenge overwhelmed the company, but not before it had spent billions of dollars in marketing.

In today’s high interest-rate environment, investors are no longer willing to fund any business indefinitely, and there has been a pullback across the market, not just in the smokeless subsector, but in everything from food delivery to cryptocurrencies. Big Tobacco always had the distribution networks and resources to take over the smokeless industry, and now it is leveraging its vast footprint to get in front of consumers. With this major shift, all of the main players barring Japan Tobacco, which is only just embarking on the journey, are earning money from smokeless products.

Imperial Brands, Philip Morris and BAT look the most interesting among the five big players in the market. BAT moved past its obsession with debt earlier this year and sold part of its stake in ITC, formerly India Tobacco Company, to fund a share buyback. It is planning to repurchase £700 million of shares this year and £900 million by the end of 2025, by which time it should have reached its target to reduce debt to a range of two to 2.5 times earnings before interest, tax, depreciation and amortisation (Ebitda) . Further buybacks seem likely. The stock is also cheap, trading at a forward p/e of 6.7 based on Panmure’s estimates, falling to six by 2026. It offers a 9.8% dividend yield .

Imperial is an exciting proposition. The company has recently focused on debt reduction and cash generation. In October 2022, it launched a series of huge share buybacks that have reduced its issued share count by 10%. Purchasing shares creates a virtuous cycle. With fewer shares in issue, less cash is required to fund the dividend payout, leaving more money for remaining investors. Management has indicated it will continue down this path. If the current trend continues, the company will have eaten itself in ten years. On top of this, there is also a dividend yield of 7.7% on offer and Panmure has the stock trading on a 2026 p/e of just 6.1.

Philip Morris is the most expensive of the bunch, trading at a 2026 p/e of 13.7, but it should deliver growth worth paying for, with pre-tax earnings set to increase by roughly 50% between 2023 and 2026 (in part due to the Swedish Match acquisition, which only closed towards the end of last year). The stock also offers a dividend yield of 5%.

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