Now Looks Like the Right Time to Quit Tobacco Companies

Source from:  business.timesonline.co.uk Nick Hasell: Tempus November 1, 2008 11/04/2008

Turning to tobacco stocks during a downturn is a habit that investors find hard to break - and with good reason. This week's third-quarter figures from British American Tobacco, the world's second-biggest cigarette maker, demonstrated that the defensive traits for which its sector is sought remain firmly intact: the company grew faster than expected in the three months to September 30, with sales from emerging markets up by a quarter on the year and its higher-priced brands, such as Dunhill and Kent, continuing to sell well around the world. That resilience is reflected in BAT's shares, down less than 8 per cent over the past 12 months, so that they have outperformed the FTSE all-share index over that period by a healthy 48 per cent. It is not alone. In relative terms, the European tobacco sector is trading at its highest level since the early 1990s, as the chart below shows. On the basis of forward multiples, tobacco stocks sit at 11 times next year's earnings, according to Nomura, a premium of nearly 40 per cent to the wider European stock market, at eight times. The inevitable question for investors is how much longer that strength can be sustained. With emerging market economies - the source of recent profit growth - increasingly under strain, with cash-strapped governments seeking ways to supplement tax revenues and with public smoking bans spreading around the world, are tobacco shares set to run out of puff? If tobacco companies are assessed on their dividend-paying potential alone, the answer must be no. Indeed, the recent government bailout of British banks - which has curbed their ability to return cash to ordinary shareholders - has only increased the relative attractions of tobacco. Whereas banks previously accounted for 22 per cent of all UK dividend income, that figure is now set to fall to just 11 per cent. That leaves BAT - which offers a secure prospective yield of 5.5 per cent - as one the FTSE 100's biggest dividend payers. Even Imperial Tobacco, never traditionally regarded as a yield stock, now joins that roster, offering a prospective 4.7 per cent return. The bigger concern must be that rising unemployment prompts a change in consumer behaviour, so that tobacco companies find it harder to pass on cost increases to recover rising raw material costs, customers in developed markets trade down to cheaper brands and the pace of those trading up to more expensive brands in emerging markets starts to slow. Nomura points that at the time of the last downturn, in 2002, Philip Morris, the maker of Marlboro, saw US volumes fall 7.5 per cent, double the drop of the wider tobacco market, reflecting its bias towards premium brands. That susceptibility helps to explain why BAT and Imperial have been busy targeting the "economy" end of the market through launches such as JPS Silver and Pall Mall. The other sensitivity in developed markets must be a demographic one: 57 per cent of smokers in the UK are classified as skilled manual workers - carpenters, plumbers and the like - who are among those most likely to be feeling the pinch. The outlook is no more encouraging in emerging markets, which account for the bulk of recent underlying profit growth at BAT and Imperial. It is reasonable to assume that recent financial market volatility will weigh on consumer confidence. Slowing GDP growth will show through in consumer spending and the rate at which the international majors are taking market shares from local producers will decline. For those companies that derive most of their revenues in nonsterling currencies, there is also issue of devaluing emerging market currencies. Of the £457 million rise in nine-month operating profits reported by BAT this week, about half of that sum was driven by the appreciaton of the dollar against sterling. The worry for next year is that those foreign exchange benefits will be offset by a weakening of the South African rand and the Brazilian real, two big currencies for BAT. The broader comfort is that the effect of any faltering of profit growth at BAT and Imperial will be mitigated by extensive cost-saving programmes – either as a result of internal restructuring or, in the case of Imperial, the postmerger shake-up after the takeover of Altadis. Both stocks may prove volatile in the short term – BAT because of this week's distribution of shares to two to its biggest shareholders, Richemont and Remgro, whose own investors may choose to sell, and Imperial because of concerns over its £10 billion of net debt, part of which matures next year. In the longer term, the risk is that tobacco's allure of relatively predictable earnings and dividend will be replaced by the stock market's pursuit of cheaper sectors that are explicitly geared to economic recovery. Either way, the inclination must be for those with profits to take them. Enditem