EUR 850.00 For Business Accounts Only

Morningstar | Moving Tobacco Trend Ratings to Negative, but Market Is Too Pessimistic on Our Picks

We have lowered our moat trend for British American Tobacco, Imperial Brands, and Philip Morris International to negative from stable because we suspect that recent evidence regarding the economics of next-generation products may signal a deterioration in Big Tobacco’s cost advantage in the long term, and because cigarette brand equity appears to be less transferable to next generation products, or NGPs, than we had initially thought. However, although we have become incrementally more concerned about moats and margins in the tobacco space, the market appears to be pricing in a dire scenario for the industry. We still believe in Big Tobacco's wide economic moats. Pricing in the cigarettes remains strong, and most markets have headroom for multiyear price increases that should more than offset volume declines. We think there is value in tobacco stocks at present, and Imperial Brands and PMI are our current picks.

Our previous stable trend rating assumed that the tobacco manufacturers' cigarette brand equity was transferable to heated tobacco. The early signs supported our assumption, with PMI marketing Heatsticks under Marlboro in Japan and Parliament in Russia, and BAT marketing sticks for Glo under Kent, a cigarette brand. In late 2016, however, PMI announced that it would de-emphasize the Marlboro brand in the European Union (it now brands Heatsticks as Heets in that market), and BAT has launched Neosticks under new brand Neo in Japan. This strategy may capture the early adopters, but it will limit the mobility of cigarette brand equity to the emerging NGPs.

We also believe that Big Tobacco's cost advantage is likely to erode if consumers adopt cigarette alternatives. This would pose risks both to margins from volume declines and to overall returns on capital from the mix effect of the growing NGP portfolio. Given the negative correlation between volumes and average cost, this is likely to lead to average cost trending higher over time.

Mr. Market has displayed wild mood swings in the tobacco sector over the past 12 months as investors have struggled to come to value the potential impact of NGPs. Last year, tobacco was the darling of consumer staples; this year, heated-tobacco growth has slowed and investors have run for the exit. We think the pendulum has swung too far to pessimism, and that current valuations seem to offer value. Imperial Brands has been egregiously punished by the market for not participating in heated tobacco and because it is facing some temporarily steep volume declines in some markets due to regulatory and taxation changes. At 10 times 2019 earnings and paying a near 7% dividend yield, Imperial is trading at multiples below its peers, below its historical averages and 20% below our GBX 3,700 fair value estimate, reflecting investors' overly pessimistic outlook. Similarly, the 32% decline in Philip Morris International over the past year appears overdone. The company has suffered a slowdown in sales of iQOS in Japan, the largest market for emerging tobacco technologies to date. Investors may be disappointed that the early adopters peaked at around 20% of the overall market, but we believe that this will moderate declines in the high-margin cigarette business, and we think late adopters may be attracted by the upcoming launch of Platform 2, a disposable heated tobacco product. At 15 times forward earnings and with a 5.5% dividend yield, PMI trades at a valuation premium to Imperial, but still offers significant value, in our opinion.