There was a time when tobacco companies seemed like the perfect stock to own. They made a frequent purchase item with incredible margins and customer loyalty like no other product.
All of this is in the past. Now tobacco stocks are running out of puff, as people head towards alternative nicotine-based products or give up altogether. Add to that professional investors and wealth managers sometimes avoiding the stocks on ethical grounds, and increasing regulation being faced by the manufacturers of cigarettes (such as US menthol regulation that is a concern among investors). Marketing and usage of cigarettes and related products has been curtailed by governments around the globe in recent years, with devastating effects for businesses operating in the tobacco industry.
Over the past year, the share price of British American Tobacco (LSE: BATS) is down by 16%, reflecting investor sentiment in the industry. Added to the company’s woes is the mountain of debt mostly accumulated from the acquisition of American business Reynolds.
Cloudy outlook
Last week, British American Tobacco announced plans to cut 2,300 jobs by 2020 in readiness for a shift towards non-tobacco products.
The company is in a difficult position. Clearly it needs to move with the times and diversify away from tobacco. Yet the bulk of its £24.5bn revenue comes from traditional cigarettes. And are non-traditional products really the answer to this? Regulation is increasing globally regarding products such as heat-not-burn tobacco and electronic cigarettes.
The safety of some of these products has been questioned too. Reports of six deaths in the US linked to vaping and up to 450 cases of lung problems have spooked some consumers. The Centre for Disease Control has advised people to stop vaping during its investigation and Donald Trump said he is considering a ban on flavoured e-cigarettes.
Yet British American Tobacco obviously thinks the market is shifting towards these products. If it is right, with its brand awareness and infrastructure, it would be in a great position to capitalise on this. However, I have some doubts that the market will grow as fast or as big as it anticipates. I think that a large proportion of usage is as an aid to quit smoking, so customers will only be retained for the short term. This will be more apparent if a flavour ban does come into force in the US or other markets.
From the ashes
Not all of the news is bleak for British American Tobacco. Revenue and profit has been increasing year-on-year, despite falling tobacco volumes. The drop in its share price also makes its price-to-earnings ratio an attractive 11. The prospective dividend is a chunky 6.5% and it could potentially be a great buy for value and growth investors.
The company also has a strong presence in emerging markets, such as Latin America and Asia, as well as a dominant position in the US. I believe this could put it in a great position when it comes to Brexit.
However, with the increased regulation and what could be a declining market, there is too much uncertainty in the industry for me at this time to buy.
