By Geoff Spiteri, BNY Mellon Investment Management EMEA
Smoking has suffered a precipitate decline in recent years but tobacco firms believe a new range of less harmful products could transform their fortunes, says Newton analyst Amy Chamberlain.
Could e-cigarettes and heated tobacco fill the void left by smokers quitting the habit? For investors in so-called ‘sin stocks’ that’s a key question in the coming months and years as a new range of ‘next-generation’ products comes to market, according to Newton analyst Amy Chamberlain.
Chamberlain, who has 23 years’ experience as a consumer analyst, highlights Philip Morris and British American Tobacco (BAT) as two of the leading innovators – the former with its battery operated IQOS (“I Quit Ordinary Smoking”) device, a tube resembling a cigarette holder, and the latter with its less slim-line glo delivery system. In Japan, the roll-out of Ploom TECH, a hybrid vape and tobacco product, is also underway.
Other delivery methods continue to blaze a trail too. Vaping of e-cigarettes – where a nicotine-infused liquid is heated to create an inhalable aerosol – currently accounts for around two thirds of the global next-generation market and continues to experience strong growth.
What all these delivery methods have in common is how much less detrimental to health they are than their combustible counterparts. A traditional cigarette burns at around 600°c (and peaks during puffs at around 900°c). In contrast, the temperature of tobacco in these ‘heated’ products peaks at about half that. This means fewer toxins – most obviously tar– are drawn into a smoker’s lungs. Likewise, with e-cigarettes, nicotine is inhaled but there is no tobacco or combustion.
Significantly, says Chamberlain, independent experts appear to be moving closer to endorsing next-generation products as being less risky than traditional cigarettes. For instance, an expert independent evidence review published by Public Health England (PHE) concluded that e-cigarettes are around 95% less harmful than smoking.1 Surprisingly, though, around 45% of people surveyed by PHE were unaware of this. Likewise, the US Federal Drug Administration is reviewing Philip Morris’s iQOS: its Tobacco Products Scientific Advisory Committee recently said the device “significantly reduces exposure to harmful or potentially harmful chemicals’.2
In the meantime, industry incumbents continue to push hard to popularise heat-not-burn tobacco. In Japan, Philip Morris and BAT have opened Apple-like retail outlets (often complete with trendy coffee shops) where potential customers can trial iQOS and glo. In the UK, Philip Morris has also opened stores in prime locations and offers mini seminars on using iQOS. In many European countries, billboards advertising tobacco products are still allowed and Philip Morris has taken full advantage of the ability to promote next-generation products. All the players in the heat-not-burn space are offering discounts on their delivery devices to entice potential customers to switch.
When smoke gets in your eyes
This is not to say there are no headwinds for the future growth of next-generation products. At the top of the list is nicotine delivery, since no company to date has been able to completely replicate the ‘hit’ associated with traditional cigarettes. Heat-not-burn tobacco products offer the nearest simulacrum but typical e-vapour products have a long way to go (notwithstanding the recent innovation of adding nicotine salts which have improved the user experience).
There is also a question about the cost of development. Currently the companies producing heat-not-burn tobacco products are at breakeven at best on the manufacture and sale of their hardware delivery devices. There are also the costs associated with educating customers on the use and advantages of these new products. Retail outlets, salesperson training and advertising where it’s permitted all create additional overheads, says Chamberlain.
Likewise, it remains to be seen how ‘sticky’ the brands associated with next-generation products will be – or how easy it will be to protect the intellectual property involved in their creation. Chamberlain notes, for example, that Korean tobacco company KT&G has started selling its own product that can be used in the iQOS device. But this does not mean investors should avoid tobacco stocks. For the truth is that tobacco, like other ‘sin’ stocks, has offered investors extraordinary returns over the past 20 years. Even as the consumption of traditional cigarettes declines, tobacco companies still appear to be in rude health, says Chamberlain.
There are good reasons for this. For one thing, the price elasticity of demand is low and increases in the tax on tobacco are actually an indirect benefit since incumbents can take the opportunity to hike prices above and beyond any additional excise duty.
In Chamberlain’s view it’s also unlikely the industry will see new entrants. “Tobacco carries a stigma,” she says. “For reputational reasons, consumer goods and pharmaceutical companies, which would in theory be best placed as new market entrants, don’t want to be associated with it – especially since it also carries the requirement for specific regulatory expertise and a different supply chain.”
This is good news for the bottom line: it makes for a virtual oligopoly with no real pressure on marketing investment and no real need to innovate in the field of combustible cigarettes. And while the decline in smoking has affected volumes, the decline has been manageable. For companies unburdened by high capex, with high margins on their core products and with limited competition from rivals the status quo is more than sustainable.
The same goes for the costs associated with the manufacturer and distribution of next-generation products. As take-up improves, companies will be able create economies of scale which should mean these new products can be at least as profitable as cigarettes, says Chamberlain.
Indeed, her long term view is that tobacco producers will remain at the apex of a market where competition is limited and where profitability consequently remains extremely robust. In her worst-case scenario, participation rates decline as next-generation products help smokers quit the habit entirely and the decline in total industry volumes accelerates. In her bull-case scenario, though, smokers consider the risk/reward dynamics of their habit and decide to migrate en masse to next-generation products. The significantly reduced harm of these new products keeps them in the category – meaning the combined volumes of combustibles and next-generation products stabilise or even rise.
She concludes: “There’s no question the tobacco industry has its challenges. Yet we believe rumours of its imminent decline are greatly exaggerated. Tobacco companies have a fantastic track record of
rewarding their investors and, given the potential of next-generation products, we think there’s no reason for this not to continue. As these products gain momentum we believe the industry can continue to thrive.”
1 Public Health England ,UK Department of Health: ‘E-cigarettes around 95% less harmful than tobacco estimates landmark review’, 19 August 2015
2 Food and Drug Administration, Tobacco Products Scientific Advisory Committee, 24-25 January 2018
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