Tobacco Earnings Going Up In Smoke?
Bettina Edmondston, Global Analyst, examines the ‘universally loathed’ tobacco sector…
Tobacco Earnings Going Up In Smoke?
During recent meetings with our clients it became clear that the tobacco sector is universally loathed. This contrasts with the wider staples sector, which seems to be over-owned and overvalued to us.
As the chart below highlights, since the start of 2018 global tobacco has underperformed the broader staples sector by 35% and the overall stock market by 38%.
Part of this is due to the derating of tobacco shares and the rerating of the remainder of the staples sector. The PE differential between the 2 has increased by over 8 points over the last 18 months:
At the same time the dividend yields on tobacco have grown to almost 2.5x those of the overall staples sector:
There are various widely known reasons for tobacco’s underperformance, such as the acceleration of combustible cigarette volume declines (see chart below), concerns about over aggressive pricing, potential new regulation from the FDA and ESG concerns.
We own two companies in the global tobacco sector namely; Imperial Brands (IMB), the deep value play on developed markets and Philip Morris International (PMI), the growth play on emerging markets and the new “Heat not Burn” technology (IQOS).
In our view share prices do not reflect the positive EPS growth and double-digit total shareholder return we expect these companies to deliver over the next five years and beyond.
In the case of IMB we see the more streamlined cigarette portfolio as very well positioned in its top 5 markets (US, Germany, UK, Australia, Spain). IMB’s brands are towards the value end of the spectrum and should benefit from consumer downtrading, which has started to happen in the US. We, therefore, do not see profits from combustible cigarettes going up in smoke!
IMB was a first mover and is now one of the leaders in vaping/e-cigarettes. We don’t know which Next Generation Product (NGP) will win, but we assume it will be a mixture of options. Imperial’s myblu has the highest market share in retail in Germany, Japan, France and Italy. It is also strong in the US and the UK. There is potential for margin increase as these products become a bigger part of the portfolio.
Some market participants seem to be concerned about IMB’s leverage. Whilst net debt/EBITDA at 2.6X is towards the top end of our tolerance levels, it is still very manageable for a company that generates significant amounts of free cash flow. We forecast £2.5-3bn of FCF p.a. on a market cap of £19bn and net debt/EBITDA to fall to less than 2X over our 5-year forecast period. However, Imperial has a £2bn disposal programme, including its luxury Cigars business, which will be complete by the end of March 2020. Part of these proceeds will be used to reduce leverage even further – which we estimate will bring it closer to 1.5x in year 5.
At the same time management is adamant – and we would agree – that the threat to the dividend is “non-existent”. We have increased confidence in the sustainability of the dividend post the recent announcement of a new capital allocation policy whereby from 2020 the dividend will grow in line with earnings. We had engaged with Management about the futileness of the old 10% annual increase in dividend and queried why they were not engaging in a share buyback program given the rating on the shares. We were therefore delighted to see a share buyback announced alongside the change in dividend policy. Furthermore, there is scope for even bigger programmes in outer years.
As ever, valuation is the key for us. The 7x PER and 10.5% yield (source Bloomberg; 09/07/19) implies that the business model is broken, and the company is in financial distress. We disagree! On the conservative view that the share holds its current 7X PER ratio, our assumption of underlying EPS growth of 3-4%, accretion from the share buyback and the yield to give us a total annual shareholder return in excess of 15%! Clearly if the company can deliver on its targets the shares will also re-rate from the current low levels!
We think if the market doesn’t recognise the value inherent in Imperial someone else will; either an activist investor, trade buyer or private equity.
The investment case for PMI is different. PMI has no direct exposure to the US and is a play on Emerging Markets. Its biggest markets include Turkey, Russia, the Philippines and Indonesia.
We have followed PMI for a while and listened to the company’s growth strategy for its “Heat Not Burn” product IQOS with interest. While we always liked the strategy, we were never comfortable with the lofty valuation of the shares. However, after two profit warnings in 2018, the shares de-rated massively and we initiated a holding in July last year.
We believe that the guidance is now much more conservative and expect upgrades to come through over the next year or two, driven by continued growth in IQOS in Europe and South East Asia, combined with slight margin expansion and the potential of a share buyback porgramme in two years’ time.
PMI’s has first mover advantage (by some distance) in “Heat Not Burn”, has strong market shares and continues to lead innovation in this space. We see it as a long-term winner in the non-combustible nicotine space. We expect PMI to be able to grow its earnings by approximately 5% per annum which combined with a 6% yield should give us a double digit total return.
In conclusion, despite the uncertain backdrop, valuations are now reflecting a huge amount of pessimism about future earnings and cash generation. Given that dividends are secure, we think the sector is massively over-sold and we have recently bought more of IMB and PMI.
Global Analyst, Saracen Fund Managers