Investing in tobacco stocks can be an ethical minefield for investors due to the ongoing health risks associated with smoking and vaping. In the UK, 76,000 people a year die from smoking according to the NHS, and 480,000 people in the US according to the Centers for Disease Control and Prevention.

Russ Mould, investment director at AJ Bell, says: ‘A lot of investors have turned their back on the sector due to ESG (environmental, social and governance) concerns, which explains why shares in stocks like British American Tobacco are relatively cheap and offer high dividend yields. They are deeply unloved.

‘While these businesses remain highly cash-generative, they are having to find new ways to attract investors and win over sceptics.’

In this article we discuss how British American Tobacco (BATS), Imperial Brands (IMB) and Philip Morris International (PM:NYSE) have fared with the shift to next generation products such as vaping and are going further to make themselves fit for the future, such as buying into health products like asthma inhalers.

REINVENTING THE SECTOR

Philip Gorham, a director of equity research at Morningstar, is optimistic about the changing face of the tobacco sector. He says: ‘The advent of e-cigarettes has created the most significant change in the tobacco industry since the 1960s.

‘Early forms of e-cigarettes have existed for a generation, but with the consumer arguably less brand-loyal and more aware of health issues than ever before, the industry is undergoing a shift to next-generation products.

‘It seems likely that cigarettes will remain the driving force of the industry profit pool for the next decade, but Big Tobacco manufacturers are nevertheless placing their bets on new categories most likely to win share of smokers.’

British American Tobacco is among the companies to have branched out from traditional cigarettes. The Dunhill, Kent, Lucky Strike and Rothmans brands owner has invested heavily in developing non-combustible products including vapes and nicotine pouches.

The company has lofty ambitions to achieve 50 million consumers of non-combustible products by 2030 and to accelerate the growth of its new category revenues at a faster rate than total revenue, reaching £5 billion in 2025.

‘British American Tobacco’s next generation product revenue was £2.9 billion in 2022; divisional revenue has grown at a 33% compound annualised rate since 2018,’ says Gorham.

‘However, the company will soon face greater competition in the US from Altria’s (MO:NYSE) acquisition of Njoy, the partnership between Altria and Japan Tobacco (2914:TYO) in heated tobacco, and the potential re-entry of IQOS, a line of heated tobacco and electronic cigarette products manufactured by Philip Morris.

‘We also expect adoption of heated tobacco to slow globally in the absence of transformational innovation.’

The move towards next generation products for tobacco companies has been a double-edged sword as although it has grabbed the attention of investors who would not normally invest in tobacco stocks, it has sparked the rise in the use of vaping among adults and children aged between 11 and 17 in the UK.

RISE OF VAPING

According to charity ASH (Action on Smoking and Health), since 2021 the proportion of children currently vaping has been greater than those smoking. This year, the figure stands at 7.6% vaping compared to 3.6% smoking. That is an alarming statistic.

ASH also says that in March/April 2023 the proportion of children experimenting with vaping had grown 50% year-on-year, from one in 13 to one in nine.

British American’s foray into next generation products and its promise to build ‘A Better Tomorrow’ has not stopped its share price falling 24% year-to-date (as of 21 August).

New proposed laws to reduce the visibility of vape products in the UK and a ban on non-therapeutic and single use vapes in Australia might have played a role in knocking British American Tobacco’s share price this year as sentiment towards the sector weakens.

While selling vapes to under-eighteens is illegal in the UK, advertisements for the products often feature on social media apps used by children. The UK government is looking into banning fruit-flavoured vapes to deter young people from taking up the habit.

WHY INVEST IN THE SECTOR?

Given the multitude of concerns around addiction and health issues, one might ask why anyone invests in the sector. The answer lies in the dividends as you can find some of the highest yields on the market among tobacco stocks.

British American Tobacco has a 9.6% prospective yield versus 8.6% from Imperial Brands. Both are much better rates than you can get with cash in the bank, even after the rise in interest rates over the past 18 months or so.

However, high yields are less attractive if the value of the shares is falling. Imperial Brands’ shares are down 16% year-to-date, meaning that an investor who bought at the start of 2023 would be sitting on a loss despite the generous dividends.

Anyone considering putting money into tobacco stocks, or if they already own them, needs to take a view whether the sector is facing a short-term blip or that it could soon return to the prosperous times of 2000 to 2016, during which shares in Imperial Brands increased more than 14-fold in value.

Imperial Brands’ shares enjoyed a good run between 2000 and the end of 2007, the latter period coinciding with the smoking ban in UK pubs, restaurants, nightclubs and most workplaces.

The stock was subsequently caught up in the global market sell-off linked to the credit crunch. It then rebounded and rose higher up to 2016, helped by investors being excited about the earnings prospects from next generation products.

The shares then fell back as it was clear that next generation product sales growth expectations were too high, and then investors started paying more attention to ESG matters, and certain people no longer wanted to invest in the tobacco sector.

The stock rebounded after the Covid-related global market sell-off in 2020 and kept rising until late 2022, helped by investors warming to value stocks including tobacco makers.

This year has been a harder slog for the sector which we can attribute to two factors. First, investors have warmed to growth stocks again and value shares are less appealing when we see this market rotation. Second, concerns about children vaping have been all over the news, which creates a headwind for companies involved in the manufacture of these products.

Imperial has an array of brands which includes JPS, Davidoff and Gauloises, and the company still has pricing power, despite regulators’ restrictions on packaging and advertising, says Danni Hewson, AJ Bell’s head of financial analysis.

In 2021, Imperial Brands’ CEO Stefan Bomhard launched a five-year plan after profit warnings, managerial upheaval and a dividend cut. For the full year to September 2023, analysts are forecasting 7% growth in revenue to £9.46 billion and 3.9% growth in pre-tax profit to £3.51 billion.

US-LISTED TOBACCO COMPANIES

Philip Morris is taking a ‘metaphorical leaf’ from the other British American Tobacco and Imperial Brands by committing itself to replace cigarettes with less harmful alternatives as soon as possible.

The world’s largest tobacco company – with 23% global market share – surprised investors in 2021 by buying UK inhaler firm Vectura for £1 billion.

This was effectively an attempt by the US tobacco company to pivot into the healthcare space. Vectura makes medicines and devices to treat respiratory illnesses like asthma. At the time of this acquisition, Philip Morris said that since 2008, it had invested more than $8 billion in developing smoke-free products.

The US tobacco company aims to generate over half of its revenue from non-combustibles by 2025.

Analysts at Morningstar have given the stock a fair value estimate of $103 per share, which implies a forward 2023 multiple of 17 times earnings per share, around 12 times enterprise value to earnings before interest, taxation, depreciation and amortisation, a free cash flow yield of 6%, and a dividend yield of 5%. The shares currently trade at $94.

‘Our valuation is at the high end of both the historical trading range of the tobacco industry and our valuation of the tobacco group because we think PMI’s leadership position in heated tobacco means it could grow not only faster than its tobacco group peers, but also faster than most multinational consumer staples manufacturers over the next three to five years,’ add the Morningstar analysts.

CAN I INVEST IN THE SECTOR VIA FUNDS?

While there is not a tobacco-specific tracker fund, several actively managed funds invest in tobacco stocks as part of a diversified portfolio.

For example, Trojan Global Income (BD82KP3) has British American Tobacco as its top holding, representing 5.2% of the portfolio at the time of writing. A further 4.5% of its assets are held in Philip Morris shares.

Man GLG Income (B0117D3) has 4.3% of its portfolio in Imperial Brands, sitting alongside investments in the banking, oil and pharmaceutical sectors, among others.

DISCLAIMER: AJ Bell is the publisher of Shares magazine. The author of this article (Sabuhi Gard) and the editor (Daniel Coatsworth) own shares in AJ Bell.

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