Friday, 5 June 2015

Investing in decline

British American Tobacco (BATS) published a gargantuan number this week: CAD$15.6bn (£8.2bn). Unfortunately, this has nothing to do with its financial results - the group made pre-tax profit of £4.8bn last year - but is instead the amount awarded to smokers by a Canadian court for "moral and punitive damages". BATS' Canadian subsidiary is liable for two-thirds of the sum.
Shareholders need not fret yet: the legal battle has already been rumbling on for 10 years, and the three tobacco companies inculpated will challenge the judge's ruling. The public smoking bans and tax increases introduced in countries ranging from Brazil through the Philippines to Turkey are of more immediate consequence. Manufacturers used to rely on emerging markets to offset falling volumes in Europe and North America, but this growth engine has stalled.
The latest government crackdown is in China, the world's largest cigarette market. On the same day as the Canadian legal judgement, Beijing banned smoking in restaurants, public transport and offices - the strictest restrictions yet introduced in the country. The direct impact on BATS and Imperial Tobacco (IMT) will be limited, as the Chinese market is virtually monopolised by China National Tobacco Corporation (although BATS did launch a joint venture with CNTC in 2013). But the move does highlight the direction of travel across the developing world.
But the fascinating thing about tobacco companies is just how successful they have been at managing decline. In 2006, BATS sold 691bn cigarettes and was worth £29.6bn on New Year's Eve. In 2014, it sold 667bn fags and attracted a year-end market valuation of £65.2bn. The figures for Imperial Tobacco show the same pattern. For investors, this is a very instructive contradiction.
Tobacco groups have wrung growth out of a shrinking market in three ways. 
1.  Firstly and most importantly, they have continually increased prices. This has worked because demand for cigarettes is infamously 'inelastic': consumers pay up even if prices rise. Moreover, in many countries the price of a packet of cigarettes consists mainly of tax. In Britain a full 77 per cent of the typical price of a premium packet is paid to the government, according to the industry lobby group. Mathematically, that means manufacturers can increase their prices by 5 per cent without pushing the total packet price up by much more than 1 per cent.
For example, in the first quarter BATS reported a particularly disappointing 3.6 per cent decline in volumes, led by shrinking markets in Brazil, Russia and Vietnam. Yet revenues at constant exchange rates rose 1.7 per cent, "driven by strong pricing, in part due to price increases in high-inflation markets".
There is a parallel here with the big brewers, notably SABMiller(SAB). Investors need not be too concerned by flat volumes, because consumers pay up for beer in the same way they pay up for cigarettes. SAB's lager volumes showed no underlying growth in the year to 31 March, but the company still delivered organic top-line growth of 5 per cent.
2.   The second key strategy for countering industry decline is consolidation. The most recent mega deal is the acquisition of Lorillard, the number three cigarette group in the US, by Reynolds, the number two. To placate the anti-trust authorities, the companies agreed to sell various brands to Imperial Tobacco, the number four, for $7.1bn (£4.7bn). The regulator finally blessed this ménage à trois last month, although the deal has yet to formally complete. Lower-profile 'bolt-on' acquisitions are more common. BATS this week announced the purchase of TDR, the market leader in Croatia and a player in other Balkan states, for €550m (£395m).
Such deals are a vehicle for cost-cutting, which boosts profits even if top-line growth is sluggish. Imperial Tobacco in particular has a strong track record for extracting value from deals. Thanks to a seemingly endless programme of cost savings - aided by advertising bans - the operating margin in its tobacco business reached an astonishing 44 per cent in the six months to March.
3.   Finally, cigarette companies have been buying into new technology: cigarette alternatives. In 2013 BATS launched the UK's first e-cigarette brand, Vype, while the Reynolds-Lorillard merger will bring Imperial Tobacco blu, a rival brand. Here the parallel is with the oil majors and their flirtations with clean energy. This month the key European players tried to stress their green credentials by writing a high-profile open letter to the UN in support of a carbon-pricing system.
Cigarette and oil alternatives make headlines and allow producers to brag about corporate social responsibility and growth. But they are a very, very long way from paying for the dividends that have long underpinned the investment case for Britain's largest companies. Fortunately, the lesson of big tobacco is that decline can be managed successfully for much longer than one might think.

 By Stephen Wilmot , 03 June 2015

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