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Are tobacco stocks no longer bulletproof?

Are tobacco stocks no longer bulletproof?

The EU’s decision not to classify e-cigarettes as medicinal products could see tobacco stocks lose their reputation as ‘bulletproof’ investments, warns Fidelity’s Aruna Karunathilake.

The European Parliament last week dropped proposals put forward by the UK Medicines and Healthcare products Regulatory Agency (MHRA) that e-cigarettes be more tightly regulated as drugs, a measure that would have seen the cost of the products rise significantly.

The EU’s actions are widely expected to be the starting point for a similar debate about the extent of regulation in the US.

A-rated Karunathilake, who runs the Fidelity UK Select fund, said: ‘The decision by the EU to reject the tobacco industry’s proposal to treat e-cigarettes as medicinal products could mark a turning-point in how the market thinks about tobacco companies as “bulletproof” investments.

‘The rapid take up of e-cigarettes in Europe and the US, combined with the regulator’s relaxed view towards them, creates a good deal of uncertainty for tobacco companies.

‘This is an industry that has always provided an incredibly defensive earnings stream and it will take time for investors to wake up to the fact that this is now being challenged by a less harmful alternative.’

Leap in e-cigarette sales

E-cigarette sales have risen exponentially over the past few years with research by Action on Smoking Health (Ash) indicating the number of UK smokers regularly using them has grown from 3% in 2010 to 11% in 2013, underlining the threat to traditional tobacco companies.

Some have moved to grab a share of the action with US tobacco giants Altria and Reynolds now major players across both markets, but others have been slower to respond.

Predictably, the debate around the merits of e-cigarettes has been driven by an array of opposing agendas, not least big tobacco, health agencies and the Electronic Cigarette Industry Trade Association (Ecita).

The health debate is a particularly thorny one. MHRA wanted e-cigarettes regulated alongside other nicotine products such as gum and patches so their quality can be assured amid concerns about the safety of products from unlicensed providers.

However, Ecita argued the cost of meeting stringent drug licensing criteria would run into ‘several millions of pounds’ for each producer and this would have to be passed on to the end consumer, pricing e-cigarettes out of many people’s reach.

Both Ecita and the likes of Ash have been pushing the health benefits of e-cigarettes heavily, with the latter pointing to the fact its research found 48% of users switched from normal cigarettes with a view to eventually quitting.

But not everyone is convinced. The World Health Organisation (WHO) said it has ‘not ruled them out’ as an effective way of mitigating the harmful effects of smoking but said it is still carrying out research in this area.

Elsewhere, a study in the medical journal The Lancet last month found e-cigarettes could be as effective as patches in helping people quit, but an earlier study by the University of Athens concluded that although less harmful than smoking, they still damage the lungs.

In the US, which previously had been ‘light touch’ on the issue, pressure is mounting for e-cigarettes to be regulated by the Federal Drug Agency after the Centers for Disease Control and Prevention (CDC) found e-cigarette use in US middle and high schools more than doubled year-on-year in 2012.

The release of its research last month prompted the National Association of Attorneys General to bring e-cigarettes under the Tobacco Control Act (TCA), which would restrict their advertising, but more significantly force producers to contribute to the Master Settle Agreement (MSA).

This is the fund into which tobacco companies pay around $6 billion a year to cover tobacco-related healthcare costs.

With Forbes estimating the e-cigarette market to be worth £1.7 billion a year and rising, political pressure is also likely to mount on bringing them under the TCA. Indeed, last month Fitch warned that declining MSA payments could potentially lead to bonds backed by it being downgraded.

Headwinds are clear

Regardless of which way the regulation of e-cigarettes goes, the headwinds facing the tobacco sector are clear and it is no surprise some investors are getting cold feet.

Fidelity’s Karunathilake said that as the threat of e-cigarettes is recognised, ‘tobacco companies will become viewed as lower quality franchises due to the emergence of a credible alternative product for the first time’.

‘The market is still some way from discounting this in share prices,’ he said. ‘For this reason I sold BAT earlier this year, a difficult decision as it is a stock I had held for all of my investment career thus far.’

Saracen investment director Daniel Leaf is also cautious, adding that on a valuation basis, tobacco stock prices are now on par with pharmaceuticals, which have growing rather than declining revenues and cash flow.

‘We believe analysts and investors have become complacent when looking at the sector,’ he said. ‘The challenges facing the sector are intensifying; e-cigarettes offer a novel and potentially profound shift in the industry’s dynamics.’

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