The tobacco industry faces tighter regulation and increasingly health-conscious consumers. However, it continues to offer a highly sustainable source of income for the long term. The potential for a rising absolute number of smokers across the world, pricing power and defensive characteristics mean that it is likely to remain a haven for income investors in the long run.
Additionally, the increasing use of next generation products such as e-cigarettes could provide a new source of growth. Therefore, with relatively high yields and high dividend coverage ratios, British American Tobacco (LON:BATS) and Imperial Tobacco (LON:IMB) could be worthy of an investor’s attention.
Over the course of recent decades, the regulations facing tobacco companies have become increasingly onerous. For example, in the UK the smoking ban was introduced in 2007, while plain packaging laws were brought in this year. Looking ahead, regulations look set to get tougher, and this could cause the proportion of adults who smoke to fall.
At the same time, consumers are becoming increasingly health conscious. The effects of smoking on an individual’s health have been well-known for many years, but in the last decade developed markets such as the UK and US have seen falls in the proportion of adults who smoke. In future, it seems likely that this trend will continue.
However, increased regulation and a falling proportion of adults who smoke may not necessarily mean that the absolute number of smokers declines on a global basis. The UN estimates that the world’s population will increase by a third between now and 2050. This could mean there is still a tailwind for tobacco companies, in terms of having a growing market for their product.
British American Tobacco, Imperial Brands and their peers have considerable pricing power.
Alongside this, relatively inelastic demand for tobacco products means British American Tobacco, Imperial Brands and their peers have considerable pricing power. This makes it highly likely that they will provide mid to high-single digit earnings growth over a sustained period. This should allow dividend growth to remain well above inflation.
In addition to price increases, earnings growth is also likely to come from next generation products such as e-cigarettes. This could help tobacco companies to capitalise on a growing demand for less harmful nicotine delivery methods, while also placating regulators due to the reduced risk nature of products such as e-cigarettes.
In time, there is scope for the development of even less harmful products than e-cigarettes which can more closely resemble the taste and feel of a traditional cigarette. If such a situation arose, the proportion of adults who smoke may not necessarily fall as rapidly as expected. This could provide an even larger market for next generation tobacco companies.
Both British American Tobacco and Imperial Brands are investing in the next generation products arena. They also have geographically diverse portfolios with high degrees of brand loyalty. These factors should allow them to capitalise on their pricing potential, as well as on world population growth.
With British American Tobacco and Imperial Brands having dividend yields of 3.5% and 4.9% which are covered 1.5 times and 1.6 times by profit respectively, they seem to offer a highly sustainable route to income.
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