The tobacco sector is a challenging one for investors. It’s traditionally seen as a defensive part of the market, but that view is hard to uphold as it comes under sustained regulatory attack. Yet it still holds plenty of attractions.
Smoke and fire
This has been a toxic year for FTSE 100 stalwart British American Tobacco (LSE: BATS), whose share price has halved since peaking at round 5500p in June 2017. Much of that damage has been sustained lately, its stock is down 20% in the last month alone to 2750p.
You know the underlying story. Smoking kills, and is in decline. Graphic health warnings, smoking bans, plain paper packaging and constant tax hikes are doing their job. In the UK, 26.8% of adults aged 16 and over were smokers in 2000, today the figure is 14.9%. This pattern can be seen across the developed world.
Falling volumes
Tobacco companies turned to emerging markets to keep the cash flowing but they cannot rely on that forever because, as Asia and the rest of the world gets wealthier, they will also prioritise their health. China now accounts for 40% of world demand (mostly local brands), yet Beijing recently introduced a smoking ban in both indoor and outdoor spaces. The trend can only continue.
British American Tobacco has fought back by promoting premium brands and battling for a greater share of a declining market. In October, it produced a bullish update stating that it made “good market share gains” in traditional tobacco, even with global volumes predicted to fall around 3.5% for the year.
The vape escape
Management is also pinning its hopes on vaping and e-cigarettes, with its global vapour business and tobacco heating products growing strongly on anticipated revenues of £900m. However, this new source of revenue is under attack from the US Food & Drug Administration, whose commissioner Scott Gottlieb recently warned that youth vaping levels are reaching “epidemic proportions,” and said he would not allow a generation of children to become addicted to nicotine through e-cigarettes.
The FDA will back this up with new restrictions on flavoured electronic cigarettes and may even ban menthol cigarettes, hitting BAT’s Reynolds American arm. Sales of menthol cigarettes in the US account for around 25% of the group’s bottom line.
Menthol arithmetic
Many of my fellow Fools see the slump in British American Tobacco’s fortunes as a top buying opportunity. And with the stock trading at just 9.3 times forecast earnings, it isn’t hard to see why, especially since the forecast yield is a whopping 7.2%, with cover of 1.5.
Earnings per share growth is slowing, but City analysts are still forecasting an increase of 3% this year and 8% in 2019. Operating margins are a fat 37.6%. The FDA’s onslaught has probably been priced in by now.
If you’re happy to invest in the tobacco sector, now could be a good entry point. British American Tobacco could benefit from a flight to quality if market turbulence continues, and sentiment could quickly reverse after this year’s brutal sell-off. Just remember that this is ultimately a dying market.