Big Tobacco Still Smoking, but For How Long?

Tobacco companies have long been the defensive stock of choice for investors, offering strong dividends and generating large amounts of cash. But as austerity packages bite and household budgets are squeezed, some analysts have questioned the continued health of the sector.

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In January, Citi analysts shocked observers by downgrading Philip Morris International (PMI), British American Tobacco (BAT) and Imperial Tobacco, based on long term projections that smoking would decline almost to zero in some markets within 30 years.

Cigarette volumes have indeed been declining globally, but this should not be confused with a decline in sales, Jonathan Leinster, a sector analyst at UBS, told

"There have been volume declines... The companies have been responding by increasing prices and in some instances improving mix. There has been consistent sales growth across the sector. Often people don't see the difference between falling volume and falling sales. The industry is not in decline in that respect," he said.

However, a series of price reductions in the Spanish market, including by Philip Morris International and Imperial Tobacco, seemed to hint that, with unemployment rising and household income stagnant, that trend might be faltering.

"I wouldn't say in general terms [the trend towards price rises] is reversing. You can get price wars where things change and change quite quickly," Leinster said.

"Spain is obviously going through some difficult economic times, the government has been fairly aggressive in increasing the minimum excise tax within Spain and that means that prices of cigarettes have risen really quite dramatically," he added.


"So from January 2009 until quite recently, the bottom end of the market had risen in retail terms by about 50 percent. When unemployment is 20 percent, or so we read, you can imagine what impact that has had on volumes," Leinster explained.

"If you do see quite quick changes in market share then the companies that are losing will react, and that's what happened in Spain," he said.

Large Cash Returns

Leinster does not see this happening elsewhere, and noted that while European markets may be stagnating, emerging markets are showing stronger growth in income, which could drive sales growth and push consumers into more premium brands. Furthermore, drops in volume due to economic factors can be reversed when overall conditions improve, he said.

"We still remain positive on the sector. It is a huge cash-generating sector and essentially speaking, what you're buying is large cash returns. It is consolidated, there's not a lot of consolidation in the short to medium term, so what you’re seeing in the sector is very high dividend levels and share repurchases as well," he said.

Euromonitor analyst Don Hedley agrees that the Spanish price battle will not necessarily be replicated elsewhere.

"Tax-driven price rises are happening everywhere, and the tobacco companies' volumes are trading downwards for a number of years, but the profits have been going up because of the pricing strength. Everybody looks to a strong market like Spain and thinks 'oh, is the era of pricing strength over?' but I certainly wouldn't see any real signs of that, and there's no signs of that in the profit growth of the companies as yet," Hedley told

However, he said that there are a few worrying signs that the "premiumization" process, where customers trade up, is faltering in the face of stalling economic growth, and that more aggressive moves by governments to regulate tobacco marketing could hit producers.

"There are little signs all over the place that consumers are beginning to trade down, and that's nothing really new. It's just a case of how fast it's going to happen. You've got to put it all together with the process by which smoking is becoming less and less acceptable in markets," Hedley said.

Australia plans to introduce plain packaging on cigarettes on January 1 next year as it looks to further curb tobacco companies' ability to market to consumers. There are fears in the market that others might look to take similar steps.

"There are other ways that marketing is being hit and tobacco is being de-normalized. But the main reason that sales are going down in the developed markets is price, and price is seen as the primary instrument of tobacco control," Hedley said. Both the US and Japan have significantly raised duty on cigarettes in the past two years.

"But while that process goes on, it's still the case that tobacco companies are achieving higher value sales," Hedley said.

In the longer term, however, Big Tobacco is looking for alternatives. Having generated large amounts of cash, and with little space for consolidation left in the industry, they have to spend on their future.

As Hedley noted, once they built conglomerates, but the negative implications of the cigarette business was thought to weigh on other business lines.

Philip Morris International announced on May 26 that it had acquired the patent for an aerosol-based delivery mechanism for nicotine.

BAT has gone one step further. In April it founded Nicoventures, a company which will actively look to develop new products to get nicotine to consumers without the carcinogenic effects of smoking.

"The two biggest tobacco companies in the world have now gone public on the pursuit of a non-cigarette product," Hedley said. "Big Tobacco really does seem to feel now that the days of the cigarette are numbered."