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Tobacco: are cigarette makers headed for an early grave?

Tobacco: are cigarette makers headed for an early grave?

Technology has forced businesses and even whole industries to adapt or die.

The last 20 years are littered with once darling stocks that failed to adapt – from Kodak not embracing digital photography to Blockbuster’s outdated retail outlets in a world of online streaming and Motorola neglecting to adapt to the rise of smartphones.

As of yet, the tobacco industry has, on the whole, remained largely unchanged in the last 100 years, with cigarettes remaining much the same.

However, the advent of e-cigarettes a few years ago, increased regulation and a lack of mass adoption by millennials, could be leading tobacco to a tipping point.

The question for UK fund managers is which out of the two UK tobacco giants of British American Tobacco (BAT) and Imperial Brands is better positioned for the future?

British American Tobacco (BAT)

For Eric Moore, who runs the Miton Income fund, it is clear which of the two businesses is streets ahead of the other.

‘Out of the two companies, BAT is further along,’ said Moore.

This perception has clearly made its way through to the share price in the last year, with BAT up 9%, while Imperial has fallen by just over 20%.  

‘BAT is talking about earning £500 million this year, with £1 billion by 2018 and £5 billion in 2022 – both figures are based on vaping (for which they are regarded to have a very good position) and on heat not burn products.’

‘Heat not burn (or tobacco heating system) is the most significant innovation in the tobacco sector since e-cigarettes,’ explained Adam Spielman, head of European consumer staples research at Citi.

‘The devices heat tobacco without burning it, which gives the smoker a smoking experience with the taste of tobacco and nicotine but without the smoke or ash and without the strong smell. By not burning the tobacco, the product releases much lower levels of harmful chemicals versus traditional cigarettes, thereby potentially reducing the health risk to users.’

Moore added that this technology could be a substitute for smoking and become more of a mass market option in the way vaping has failed to become.  

‘The hope – and I mean very, very bull market hope – is that if you can demonstrate that the heat not burn tobacco is really not that much worse for you than things we do anyway, like drink coffee or eat meat, then maybe participation rates could increase again.’

Moore noted that although American firm Philip Morris International is the market leader in heat not burn technology, BAT is a clear number two.

This technology also opens up new markets for British American Tobacco and Spielman predicts that heat not burn technology could account for a 27% share on the low end of the Japanese cigarette market by 2022, and 66% on the high end.

Imperial Brands

Imperial, on the other hand, is investing far less in next-gen technology. 

Moore said: ‘What Imperial Tobacco says is that it is still very early days and although they have a vaping product, they are not investing in heat not burn.’

According to Moore, Imperial is opting for a ‘fast follower’ model, rather than trying to be first.

Although at first glance this seems like a negative, in the tech space some of the best-known names have been fast followers, such as Google and Facebook.

Imperial does have one advantage over its rival though in that is it is cheaper. This was highlighted by Neil Woodford this summer when he sold out of BAT, a stock he had been invested in since the peak of the dot.com bubble.

‘We still retain some exposure to tobacco through Imperial Brands, which remains undervalued in our view,’ Woodford said.

In a recent update, he stated: ‘The US Food and Drug Administration has proposed a new regulatory ‘roadmap’ to address the issues of addiction. However, we think that it [Imperial Brands] could ultimately be beneficial for the company, as we see this as the beginning of a process to deregulate next-generation products.’

He added the company remains a highly cash generative business with a good track record of growing its dividend – by almost 10% a year over the past five years.

‘The shares, in our opinion, have not looked as attractive as they are currently, for several years.’

Although BAT seems to be winning the tech battle, the truth at least in the short-term is that tobacco is still where the money is.

‘These [next-gen] products are still a lot less profitable than selling tobacco. That’s the trouble. Selling tobacco is one of the most profitable things you can do in the world. Next to that, anything else just looks rubbish in comparison,’ Moore added.

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Eric Moore
Eric Moore
49/85 in Equity - UK Equity Income (Performance over 3 years) Average Total Return: 14.53%
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