Big Tobacco’s bets on smoking alternatives are starting to pay off. The UK’s British American Tobacco expects its non-combustible business to turn a profit by 2025, while at Marlboro maker Philip Morris International almost a third of revenue comes from these products.
But, as PMI’s chief financial officer Emmanuel Babeau made clear in an interview after results this week, the reduced-risk business model relies first on creating smokers and then converting them.
When asked about a significant rise in cigarette sales to above pre-pandemic levels in the Middle East and north Africa last year, despite PMI’s declared aim to “unsmoke the world”, Babeau told the Financial Times on Friday: “Our ambition is to convert smokers to our [reduced-risk] product. If we lose the link to the smoker we can’t convert them easily to the product.”
The damage tobacco continues to wreak on health leaves some investors unconvinced by businesses transformation efforts. One top-10 shareholder in Imperial Tobacco said: “The problem is that tobacco is almost becoming uninvestable. A lot of investors are weighing up excluding it from their portfolio.”
After the fallout from mass US litigation in the 1990s, cigarette makers became a popular investment because of their reliable shareholder returns. Big Tobacco had “one of the most consistent earnings growth in the world with 100 per cent of cash generation going back to shareholders,” said Jared Dinges, an analyst at JPMorgan.
Some are happy to continue backing the sector. For Duncan Artus, chief investment officer at Cape Town-based asset manager Allan Gray, the surge in illicit cigarette sales in South Africa during a pandemic ban on tobacco proved one thing: “Cigarettes are hard to quit.”
Allan Gray more than tripled its stake in London-listed British American Tobacco last year and is the Lucky Strike maker’s fifth-largest shareholder with a 3 per cent stake.
Cayman Islands-based billionaire Kenneth Dart, an activist investor in distressed debt, was another to increase his stake in tobacco, building the second-largest stakes in both BAT and Imperial Brands last year.
But they are rare figures in an investment community turning its back on tobacco.
Almost 70 per cent of US large-cap equity managers had jettisoned tobacco from their portfolios by June 2018, with little impact on performance, according to a 2019 study by Seattle-based asset manager Russell Investments.
This trend has pushed companies to develop reduced-risk products, although some are further ahead than others.
BAT comes second, but trails PMI by some margin on Friday reporting that 12 per cent of revenues were from non-combustible products last year. That figure is 3.5 per cent for Imperial, while Altria, maker of Marlboro in the US, and Japan Tobacco International do not disclose these sales.
The varied progress is reflected in stock prices. While PMI’s stock has recovered to January 2017 levels, when prices began to slide because of concerns over declining smoking rates and tax threats in the US, shares in BAT and Imperial are down 36 and 50 per cent, respectively.
Strong performances in reduced-risk can offset fears about a company’s long-term future, Artus said, adding: “Combustible makes up almost 100 per cent of the profits but people look at next-generation products. It’s solely what the share price moves on.”
But, as a top-10 shareholder in Imperial pointed out, investors selling out of tobacco offer an “opportunity for [companies] to be buying back their shares” and bolster the price.
BAT on Friday announced that it will buy back £2bn of shares in the next year and has not ruled out further returns. PMI last year launched a three-year buyback programme up to $7bn. Imperial is also expected to launch a buyback this year.
While these offer short-term shareholder returns, tobacco companies ultimately want to be considered sustainable investment prospects. Though there has been a regulatory crackdown on vaping in the US, the UK’s NHS found vaping is 95 per cent safer than smoking cigarettes.
BAT says a broader perspective on ESG is emerging, where “investors are prepared to engage in stocks that are transforming, when in the past they may have taken a more exclusionary approach”.
Babeau said investors can see the company’s “fundamental transformation” and that its strategy of providing smoking alternatives, “promises to deliver substantial public health benefits over time”.
PMI’s takeover of inhaler maker Vectura last year and BAT’s investment in cannabis and the launch of a biotech this year show how companies are seeking to diversify.
But many investors remain sceptical. Another top-10 shareholder in BAT said: “I don’t think tobacco stocks will ever have a place in ESG or sustainable products — this would represent too much of a shift, given that they are the most widespread exclusion from portfolios.”
Sébastien Thevoux-Chabuel is wary of the scale of change required. The head of responsible investment at French asset manager Comgest, which excluded tobacco stocks in 2016, said: “The transformation . . . needed is so gigantic and so risky that we wouldn’t be able to get conviction on the stocks to invest in the tobacco sector, even if the companies transition to reduced-risk portfolios.”
Such attitudes cast doubt on long-term investment in tobacco. “If in 10 years [reduced-risk revenue] is very big, there might be pressure from investors to split the company,” said Artus.
FT Asset Management newsletter
Our weekly inside story on the movers and shakers behind a multitrillion-dollar industry. Sign up here
It is a strategy that Stockholm-based Swedish Match has opted for, planning to separate its combustible and non-combustible businesses this year. Though analysts do not expect such moves to spark a rush to buy stocks: “Tobacco — even without combustion — [is] still too difficult to explain to fund investors,” Panmure analyst Rae Maile wrote in a recent note.
Yet South Africa’s experience suggests the world is not ready to give up on cigarettes. “You want combustibles to be replaced,” Jonathan Fell, a partner at consumer goods investment house Ash Wood Capital said. “But the traditional tobacco business isn’t going to disappear for a while. It’s a very sticky habit.”