This article was taken from the December 2023 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications
The tobacco sector has long been seen as a controversial destination for investors to park their money. In many respects the scepticism is justified. Environmental, social and governance (ESG) concerns surrounding the sale of cigarettes are hard to argue with. The sector is also undeniably in decline. The number of people who smoke in developed nations has been in decline since the 1970s and growth in emerging markets seems to be grinding to a holt. That said, large amounts of institutional money is still invested with companies such as British American Tobacco (BATs) and Imperial Brands (IMB). These are companies with market capitalisations in the tens of billions and we ignore them at our peril. While the industry is in decline, the speed with which it does so remains to be seen. If markets have overestimated how quickly demand will dry up for so called ‘combustibles’ then there might be an opportunity for investors to generate a good return based on cash conversion, dividend yields and revenue growth driven by price increases.
In this article we will look at both the sector and, more specifically, at Imperial Brands. We have chosen to focus on Imperial Brands due to some substantial outperformance when compared to the likes of BATs in recent years. We are aware that this is a controversial topic, and we would like to stress that this is not investment advice. However, this is an interesting case study in how investment opportunities can arise in decaying markets and it certainly warrants discussion.
There should be little doubt that the wider tobacco sector has passed its peak. The investment rationale for any of these companies is not based on increasing future demand or expansion as is often the case for companies that we analyse in this publication. Earlier this month, British American Tobacco made headlines when £25bn worth of its American business went up in smoke on the back of several write-downs. This was paired with a reduction in the speed at which earnings are predicted to grow, which together caused significant harm to the share price. It is evident from this that concern for the wider sector is warranted. Businesses that operate in sectors such as this generally have two options available to them; generate as much revenue as possible while liquidating stock, or transition into new markets. Philip Morris and British American Tobacco have attempted to transition away from the ‘combustibles’ market with varying degrees of success while Imperial Brands seem content to keep the majority of its business focussed on its established tobacco brands.
This is what makes Imperial Brands interesting. The company is buying back shares at a truly incredible rate and its new management team has demonstrated an ability to set and meet realistic targets for itself, helping to boost shareholder confidence. In 2022 it bought back £1bn worth of shares, representing 5.5% of its total market capitalisation and management have indicated this a trend that is set to continue. At this rate it will have bought back all outstanding shares decades long before cigarettes become culturally insignificant. This buyback program is one of the things that has fuelled IMB’s outperformance relative to the wider sector in recent times. BATs has stated that it has no intention of starting a buyback program until its debt levels become more manageable and, with growth in its next generation products (i.e. electronic cigarettes) being called into question due to legislative pressure across the western world, its inability to engage in share buybacks has hamstrung it when compared to IMB.
From an investor’s perspective, IMB’s dividend yield and cash conversion are things that make it attractive. While there is the prospect for mid-single digit revenue growth over the short and medium-term, this will largely depend on price increases and not an increase in the volume of sales. The number of smokers is declining and there is no escaping this. The investment case that is to be made here is that the speed of this decline has been exaggerated in market predictions and that investors will be able to make a good total return once the 8.03% dividend yield is factored in. There does appear to be some evidence in support of this claim. Analysts have pointed out that even if absolute bans on smoking do come into place for people of a certain age, the population of smokers will still take decades to dwindle. This provides companies such as IMB with decades of predictable cash flow.
Ultimately only time will tell if smoking’s decline has been exaggerated or not. There is a good deal of political will behind banning and further taxing cigarettes in much of the western world with countries such as New Zealand banning future generations from purchasing them altogether. Betting against market expectations is never going to be a risk-free move, but Imperial Brands is an interesting example of a company that appears happy to generate as much profit as it possibly can from a declining industry. It serves as reminder that returns can be found in a variety of places, not just in emerging growth companies. Cigarettes kill, but it remains unclear if quitting tobacco will be good for your portfolio’s health.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.