Takeaway: As smoking rates ratchet down across the developed world, emerging markets may hold the key to Big Tobacco’s future.

MARKET WATCH

Big Tobacco just got more expensive: Industry giants Altria and Philip Morris recently announced that they will be implementing price increases on all their cigarette brands, a move that has inspired bullishness among analysts. Moves like these are becoming commonplace within the Big Tobacco space. For years, tobacco companies have offset declining volumes with higher unit prices. But this strategy has an expiration date—namely, the point at which prices get too costly for the average smoker. Instead, the industry must bet on geographic positioning to power its future growth.

How has Big Tobacco fared lately? While the headline revenue growth figures appear relatively strong, they mask a dramatic decline in cigarette consumption. Data from the World Health Organization show that the annual number of cigarettes smoked worldwide peaked in 2012 at 6.1 trillion. This figure has receded in each subsequent year, hitting 5.6 trillion in 2016—the fewest cigarettes smoked since 2003.

Does Big Tobacco Have a Long-Term Strategy? - chart2s

In reality, the industry’s troubles far predate the 2012 inflection point in global cigarette consumption. As we noted in our previous piece on the subject (see: “How (and Where) to Bet on Big Tobacco”), more than the entire increase in the number of smokers worldwide since 1980 has been driven by population growth. Declining prevalence (smoking rates per 100 population) in most regions worldwide means that, as population growth slows, we will begin to see a steepening decline in the number of smokers. This is great news if you’re a public health official. It’s terrible news if you’re a Big Tobacco executive or investor.

 For years, Big Tobacco has been compensating for the decline in smoking prevalence by raising its prices. In 2001, an average pack of cigarettes cost $3.73 in the United States. By 2016, that same pack cost $6.42, a 71% rise. Contrary to popular opinion, this rise has been driven mostly by pre-tax, not post-tax, prices. Since 2009, in fact, the increase in total per-pack cigarette prices can be entirely attributed to companies raising their pre-tax prices; taxes have been flat at around 40% of the retail price.

Why has Big Tobacco been raising prices? In a word, because it can. A cigarette smoker is the very definition of the price-inelastic consumer—which has always given cigarette producers enormous potential pricing power. Historically, however, that power has been restrained by interfirm competition. Through most of the postwar era, there were as many as seven major producers, each fighting to gain market share and often cutting prices in order to do so. But after fifteen years of successive mergers and acquisitions, the U.S. industry is today dominated (over 80% of sales) by just two firms: Altria and British American Tobacco.

As the competition declined, the pricing power grew. But price hikes are not a sustainable strategy for long-term growth. At some point, the price-elasticity of demand rises above negative one: A combination of less consumption plus consumers turning to substitutes (everything from nicotine gum to bootleg smokes) starts to bend the revenue curve down. Big Tobacco may already be reaching that point. One key bit of evidence is that, state by state, the final price may already be self-defeating in terms of revenue. In the eleven states where the tax per pack is over $2.00, higher cigarette tax rates are actually negatively correlated with cigarette taxes as a share of total state revenue.

What’s left for Big Tobacco? The industry’s best hope is to establish a foothold in markets that share three criteria:

  • rising smoking prevalence;
  • strong population growth; and
  • low- to middle-income grouping.

Our first criterion is rising smoking prevalence. World Health Organization data show that today’s heaviest-smoking regions are not necessarily tomorrow’s. The Middle has the highest projected 2025 prevalence at 24.6%; in 2010, that figure was just 19.8%, third-highest among all regions. In fact, the Middle East is one of just two regions where smoking prevalence is on the rise. The other region is Africa, where prevalence is expected to rise from 13.9% in 2016 to 18.1% in 2025.

Does Big Tobacco Have a Long-Term Strategy? - chart3s

Our next criterion is strong population growth. We can look a little further into the future here using the U.N. Population Division’s medium-fertility projections. These data show that Africa is expected to register the strongest overall population growth from 2010 to 2040, with a CAGR of 2.5%. As in prevalence growth, the Middle East ranks second in expected population growth, with a CAGR of 1.5%. These two regions are the only ones in which total population is expected to grow faster than 1% per year.

Does Big Tobacco Have a Long-Term Strategy? - chart4s

These first two criteria are the most important ones for Big Tobacco, because together they can be used to quantify the growth of the number of smokers in each region. After all, population growth times prevalence growth equals consumption growth. Our next chart shows just how important geographic positioning is for Big Tobacco. The number of cigarette smokers in Africa can be expected to nearly triple from 2010 to 2040 (up 284%). The number of smokers in the Middle East will more than double (up 139%). In every other WHO region, consumption will register a net decline.

Does Big Tobacco Have a Long-Term Strategy? - chart5s

One final criterion to consider is low- to middle-income grouping. Research has demonstrated that cigarette smoking prevalence has a negative correlation with income. Big Tobacco thus stands the best chance in low- to middle-income societies that will likely take decades to reach the higher-income stage at which prevalence begins to decline. Of the six regions we’re investigating, Africa is the one with the highest share of low-income countries, followed by Southeast Asia and the Middle East.

In aggregate, the most promising markets for Big Tobacco over the next two decades are Africa and the Middle East. It’s not particularly close. In the middle are Southeast Asia and the Western Pacific. The least promising markets are Europe and the Americas. Which firm is best prepared for this new strategy? British American Tobacco enjoys the best geographic positioning of any U.S. exchange-traded Big Tobacco firm, earning an estimated 18.4% of its revenue from Africa and the Middle East. Philip Morris comes in second, generating 13.9% of its revenue from these regions.

Better yet for investors, British American Tobacco’s relative geographic advantage has not been priced into the stock. The company is by far the most affordable on a price-to-earnings basis, with a P/E of 11.9—compared to 14.8 for Altria and 17.9 for Philip Morris. Adjusted for growth, British American Tobacco looks just as attractive: The firm has a PEG ratio of 2.6, virtually tied with Philip Morris (2.7) and ahead of Altria (2.1). What’s more, British American Tobacco pays out a higher dividend yield (6.7%) than either of its competitors.

Bottom line: For investors looking for a long-term and defensive dividend machine that is well-positioned globally, British American Tobacco is worth a look.

TAKEAWAYS

  • Expect Big Tobacco to change its approach. Cigarette consumption is down in most developed markets, a trend driven by declining smoking rates. For years, rising per-pack prices have masked the decline. But a strategy built on endless price-hikes has a shelf life. Instead, a more viable strategy would be to establish a foothold in low- to middle-income economies with rising smoking prevalence and strong population growth. The Middle East and Africa check all the boxes. Of all Big Tobacco firms, British American Tobacco is the best-positioned in these markets—and its relative affordability makes it the clear choice for willing investors.
  • Recognize that the industry welcomes closer regulation. Regulation is a tailwind, not a headwind, for market-leading tobacco companies. Consider the case of Philip Morris, which in the early 2000s embraced a bill that would eventually place the industry under FDA oversight. While the move confused and infuriated competitors, it proved to be a huge win-win for Philip Morris itself. In exchange for having Congress limit its product and tort liabilities and thus hedge its downside political risk, the company agreed to allow the FDA to gradually kill off the cigarette market with advertising bans and mandatory product warning labels—virtually locking in its market dominance.
  • Don’t buy the hype surrounding “reduced-risk products.” Late last year, Altria bought a 35% stake in Juul, a leading e-cigarette manufacturer. Philip Morris, meanwhile, owns one of the leading tobacco-heating devices on the market, the iQOS. Company chief executive André Calantzopoulos even says, “We want to move out of cigarettes as soon as possible.” But this is a precarious strategy. It would take a huge leap of faith to bet on Big Tobacco to engineer a seamless transition to a smokeless future. And even if the industry does manage to accomplish this daunting feat, there’s no guarantee that it is equipped to lead that future.
  • Know the pros and cons of “sin” investing. Sin stocks feature less analyst coverage, less liquidity, and smaller representation in “norm-constrained” institutions such as pension funds than otherwise comparable stocks. They are also more vulnerable to unpredictable changes in the legal and regulatory environment. On the other hand, sin-stock investors probably benefit from a “boycott risk premium”—in other words, they are likely to generate an excess return that can only be explained by their bad reputation. As a rising number of mutual funds and hedge funds join the ESG-style stock-screening movement, a few others (like VICEX) have done very well by leaning hard the other way with a relatively small AUM.