Share prices double for industry stalwarts

Cigarette makers prove a temporary haven in tough times, writes Richard Wachman.

Cigarette makers prove a temporary haven in tough times, writes Richard Wachman.

The global financial crisis has claimed many scalps - governments, banks, fraudsters by the dozen - but it has given a surprise fillip to one of the most controversial sectors, the tobacco industry.

The stock prices of stalwarts such as British American Tobacco and Imperial Tobacco have hit record highs in the past 12 months - with BAT shares in London doubling to #30 ($43.90) as investors fled bank and retail shares for havens.

Never mind that cigarettes kill 6 million people a year and the industry faces an onslaught from health campaigners who want to extinguish its commercial viability. On global stock exchanges, tobacco firms have been among the biggest beneficiaries of the financial dislocation in the developed world.

Cigarette manufacturers are viewed by brokers as defensive stocks. They offer the holy grail of a predictable dividend yield of about 4 per cent or more, much higher than the interest you would get from the bank, as well as a steady growth in earnings that feeds in to rising stock prices, ensuring capital growth.

Martin Deboo, analyst at Investec Securities, says: "These stocks are about the closest you can get to a bond on the stock market in that they offer a relatively stable income stream, not easy to find in the equities space."

You may think this success puzzling when sales volumes are falling about 2 per cent a year (excluding China which is dominated by state-run monopolies), fewer people in the developed world are smoking and governments are forever slapping higher taxes on manufacturers.

Analysts say companies have found a neat solution to the problem. Not only do they pass on tax rises to smokers, as one would expect, they also impose an additional price increase to offset the lost sales that are inevitable every time excise duties are raised.

A bigger tax burden provides the tobacco multinationals with the cover to boost profits and revenue by pushing through what critics say are inflated price increases. Protests from smokers are given short shrift because they are viewed as undeserving of public sympathy.

The mathematics of the business explains how companies such as Imperial Tobacco, which has about 40 per cent of the British market, has boosted operating margins over 15 years from 45 per cent to 65 per cent. Deboo says the margins are high by stock market standards and show no sign of abating.

The tobacco companies have escaped the shadow of the 1990s when litigation in the US hung over the shares. An industry-wide settlement of claims in 1998 began to change sentiment.

Michael Prideaux, director of corporate and regulatory affairs at BAT, admits "life is good at the moment" and trumpets the company's unbroken record of rising profitability in recent years.

Rather than dwell on BAT's stellar share price performance, he focuses on business fundamentals. "A real positive has been the opening up of eastern and central Europe," he says, where BAT last year generated income of #1.7 billion and operating profits of #360 million.

He takes issue with campaigners who say the industry is growing only because of lax regulation in developing countries where the upwardly mobile, as well as the not-so-upwardly mobile, are consumers of the biggest BAT brands - such as Dunhill, Kent and Pall Mall.

"Regulation is pretty tight everywhere you would be surprised how strict they are in a country like Djibouti," he says. "It's a myth that emerging economies are a soft touch."

That assertion is hotly disputed by anti-smoking groups such as ASH (Action on Smoking and Health).

Prideaux admits BAT is focusing on developing regions, "but only because in countries such as India, incomes are rising per capita and there is a burgeoning middle class ... so the growth potential is superior to what is on offer in more mature markets."

BAT's figures show the Asia Pacific as the biggest contributor to profits and revenue in 2010, at #1.3 billion and #3.8 billion respectively, ahead of western Europe and Africa/ Middle East.

How long can share prices remain this strong?

The question intrigues City of London investors, so it was with some alarm that last year they read a note by Adam Spielman, analyst at Citigroup, titled: "What if the last smoker quits in 2050?" Spielman does not envisage problems in the short term as pricing power remains strong. But in perhaps 20, 30 or 40 years' time, who knows?

"There will come a time when the percentage decline in volumes is such that price increases can no longer ensure a stable top [revenue] line," he says. "For example, if you assume the industry will not be able to price up enough to offset volume declines of say 6-7 per cent ... then that implies the pricing mechanism will not be able to maintain the profit pool in cigarettes in the UK past 2020 (the percentage of the British adult population that smokes has fallen from 52 per cent in 1960 to 20 per cent in 2008).

"By extension, a similar pattern will hold in much of the rest of Europe, Canada and Australia."

He argues the rate of decline is increasing, so there is a real possibility - under one plausible scenario - that by 2050 "there will be no smokers left in many developed countries".

Then, Spielman drops another bombshell: "Smoking trends and regulations in emerging markets are often only five to 10 years behind those in developed markets."

That raises the prospect of an industry heading towards extinction. "No one can know how it ends," Spielman says.

But until then the tobacco industry remains one of Britain's few recession-busters.

Guardian News & Media

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