Regulatory Threat Hits European Tobacco Growth Prospects

Source from:  Bloomberg 10/29/2014

Tobacco profit growth in Europe will be more subdued than previously predicted as smokers switch to cheaper brands and tighter regulations turn people away from lighting up, according to Moody's Investors Service.

Operating profit will probably rise 2.5 percent to 3.5 percent in the next 12 months to 18 months, excluding currency fluctuations, down from an earlier estimate of 4.5 percent to 5.5 percent, the ratings company said today in a report.

"Sluggish economic growth and subdued consumer confidence have resulted in a trading down to cheaper brands, while tighter regulation and growing awareness of the effects of smoking on health mean fewer consumers are taking up the habit," Lola Cavanilles, a Moody's analyst, said in the report.

Tobacco companies such as British American Tobacco Plc (BATS) are responding to a long-term decline in consumption by raising prices, seeking growth outside western Europe and developing alternative products including electronic cigarettes. While cash-flow generation remains strong, volume will continue to slide in the region and "price increases will still lag," Moody's said.

The Tobacco Products Directive, which is being implemented gradually in the European Union through 2016, strengthens existing rules and introduces new constraints on e-cigarettes. The regulations will slow earnings growth as the European Commission expects the number of EU smokers to drop by 2.4 million over five years, Moody's said.

Plain Packaging

The push by lawmakers to introduce plain packaging in Ireland, the U.K. and France may eventually deprive companies of the "brand value" of their flagship products, according to the report. BAT is pushing four global "drive brands" -- including Dunhill and Lucky Strike -- to increase market share, while Imperial Tobacco Group Plc, Europe's second-biggest cigarette company, gets about 65 percent of its profit in the EU with brands including Davidoff.

BAT said last week that shipments declined 1 percent in the nine months through September, with margins narrower than expected in some key markets. Large tobacco companies may struggle to improve profitability as they adapt their costs to chasing declining volume, Moody's said.

"Companies have faced extra costs and difficulties associated with reducing capacity including political pressure, opposition of trade unions, and the cost of shipping and redundancies," the report said. Nonetheless "margins have remained reasonably stable or improved in the past five years with the exception of Swedish Match AB. (SWMA)"

Credit Ratings

Imperial and BAT will need to repair their balance sheets, Moody's said, after they complete transactions related to the acquisition of Lorillard Inc. (LO) by U.S. rival Reynolds American Inc. (RAI), in which BAT has a 42 percent stake. In July, Moody's warned that Imperial's leverage ratio may lead to the company losing its investment-grade credit rating.

Both companies, along with Swedish Match and Philip Morris International Inc., are committed to "generously rewarding" investors, though share buybacks are being scaled back to reduce debt, Moody's said. Enditem