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It’s an agonising decision for some and a trivial matter for others: should you invest in an industry that the World Health Organization says kills over half of its consumers and is responsible for the death of 7m people a year?
From a fundamental point of view, tobacco shares present an “extremely attractive” investment proposition, says Andrew Dittberner, chief investment officer at Old Mutual Wealth Private Client Securities, not least of all because of the industry’s impressive compounding abilities.
“The ability to compound is driven by robust pricing power, a high level of cash generation, translating into high-quality earnings, and generous, sustainable dividend payments.
“The defensive nature of the businesses also makes for relatively stable earnings profiles, while the management teams of the larger tobacco companies have shown themselves to be prudent allocators of capital,” he explains.
The counter-argument
But a July 2017 report by Euromonitor International shows that sales of tobacco steadily declined across South Africa in 2016.
“With negligible real gross domestic product (GDP) growth, inflation reaching 6% and the unemployment rate rising to 27%, manufacturers were further challenged by rising duties, whilst dealing with increasingly price-sensitive consumers.
Nevertheless, the decline in volume sales was mitigated by the strong performance of smaller categories, such as fine cut tobacco,” the report states.
“The health and wellness trend, which is expected to prevail in the future, will contribute to lower demand for tobacco. On the other hand, intense competition will shrink profit margins and force smaller players to exit the market,” says Euromonitor.
Future gains were likely to be seen across the combustible and vapour product offering, with this trend particularly noticeable amongst millennial smokers.
Euromonitor observes that the “glamorisation” of variants introduced to the market in 2016 prompted existing tobacco consumers to trade up, while drawing in non-smokers.
Local cigarette manufacturer Gold Leaf Tobacco (GLT) Corp, which focuses on economy brands, posted the highest volume growth in SA in 2016.
It benefitted from the depreciation of the rand while imported brands struggled to manage inflating unit prices.
Despite remaining a relatively small player compared with British American Tobacco (BAT), GLT moved closer to rivals such as Philip Morris SA and JT International.
GLT earlier this year announced plans to establish a manufacturing facility in neighbouring Zimbabwe as a springboard into the region.
The domestic tobacco industry’s reputation has also been recently soured by claims that JSE-listed BAT is to face an official investigation by the UK’s Serious Fraud Office after allegations that executives bribed several African officials in a bid to relax tobacco laws.
Currently trading at around R814.73 a share on the JSE, the company announced in August that it would instigate its own internal investigations into the alleged activities.
Impending legislation
Retail volume sales are expected to continue to decrease after the department of health in 2016 proposed further amendments to tobacco legislation, including a draft bill on plain packaging.
But Dittberner argues that the tobacco industry has, and always will be, highly regulated. “The recent news around reducing the nicotine content of cigarettes was not new to the industry players,” he says.
“They have overcome regulatory hurdles in the past, and while the announcement has created some noise in the industry, we do not believe it is something that materially impacts the industry in the near term.”
Tobacco Institute of Southern Africa chairperson Francois van der Merwe, meanwhile, expresses concern that any impending legislation that could potentially exacerbate the “catastrophic” levels of illicit trade warrants close scrutiny and may be legitimately questioned.
Since the current legislation appears to be achieving the department of health’s objective of reducing tobacco consumption, questions could be raised regarding the purported need for further, more extreme regulation locally, he says.
Levels of illicit tobacco in SA rate among the highest in the world. “Clearly, the current legislation is not addressing this scourge.
“Not only is the fiscus negatively affected with losses of more than R27bn between 2010 and 2016, but so too are the objectives of the department of health as illicit traders, by bypassing taxes and duties, are able to sell a pack of 20 cigarettes for as little as R7, making them far more accessible to the public, including the youth,” he comments.
Where to invest?
With the industry becoming increasingly consolidated, investment options in tobacco have narrowed.
The net result of the recent consolidation of Reynolds and BAT is that there are only a few companies that have significant market share in the global market.
“The problem for smaller, lesser-known tobacco companies is that smokers are very brand-conscious and loyal, thus it is difficult for these companies to take market share, especially in established markets.
“Locally [on the JSE], only BAT is available, thus limiting local investors’ choices. However, the recent regulatory announcement did provide a decent entry opportunity for investors looking to get in at lower levels.
On the global front, Imperial Brands is our preferred pick, due to valuation considerations and the exposure to both developed markets, as well as a number of high-growth markets,” advises Dittberner.
This article originally appeared in the 7 September edition of finweek. Buy and download the magazine here.
