The tobacco sector looks ripe for consolidation. Already in recent months, sector heavyweight British American Tobacco has sought to merge with Reynolds. There are also continued rumours about a potential re-merger between Altria and Philip Morris. This scope for M&A activity is coming along for two main reasons, in my opinion.
First, cigarette volumes are falling. In 2015, global cigarette volumes were 1.8% lower than in the previous year. In my view, this trend is likely to continue in the short run as higher pricing, a switch to reduced risk products (RRPs) such as e-cigarettes and a more health-conscious consumer makes cigarettes less appealing to new and existing customers.
Second, the RRP space is likely to require significant investment in what may prove to be an ‘arms race’ for tobacco stocks. New products and new innovations which gradually replicate the taste and feel of a cigarette, but with less harmful health consequences, mean the financially more powerful players in the sector could gain an advantage.
Further, I believe Imperial Brands (LON:IMB) has now become a more obvious bid target following its 9% share price fall in the last six months. The continued weakness of sterling could also make its shares more appealing to a foreign suitor over the medium term.
A worsening cigarette volume outlook
I think the outlook for cigarette volumes in the next few years is challenging. I believe the trend which has been in place for the last few years will continue, since there is a lack of clear positive catalysts to create a step-change in demand.
Part of the reason for reduced volumes is action taken by tobacco companies. They have made cigarettes increasingly unaffordable for many consumers in the developed world in particular. For example, in the UK the average price of a packet of 20 cigarettes has risen by 86% in the last 10 years. The price elasticity of demand for tobacco is relatively inelastic, which means demand does not reduce by a commensurate amount as prices rise. However, consumers will still reduce their consumption, or even turn to the black market, when prices rise.
Consumers are also becoming more health conscious. This is taking place in the developed and developing world, which I feel is making cigarettes less popular. This partly explains the switch to e-cigarettes by many consumers. That technology (or similar) has been around for many years, but it seems consumers are now willing to persist with it. Similarly, increased regulations in key developing markets such as Russia and across the developed world have also worsened the volume decline in my view.
RRP costs
As in any declining industry, consolidation is more likely. It becomes even more advantageous to generate efficiencies through size and scale. In tobacco, this would normally mean production synergies. However, given the scale of the opportunity which RRPs present, I believe consolidation is also highly likely due to rising development costs.
As in any declining industry, consolidation is more likely.
Altria and Philip Morris already have a deal in place to work together on the next generation of RRPs. In my view, e-cigarettes may prove to be the first in a long line of healthier nicotine-delivery products. Therefore, I think there could be a period of intense innovation which will require significant investment in R&D. Although Imperial Brands and other tobacco stocks already have strong balance sheets and cash flow, in my opinion the company with the deepest pockets could win the race to produce an RRP which mirrors the sensation of tobacco, but has no negative health effects.
Therefore, I believe it is in the interests of tobacco companies to join forces not only through agreements to work together, but also in pooling their resources through M&A activity.
Imperial’s appeal
Since Imperial Brands’ share price has fallen 9% in the last six months, it now has a P/E of 15. Given it is forecast to register a rise in EPS of 9% this year, I feel this represents good value for money. Further, its brands could be a good fit with a potential suitor, since it owns one of the major e-cigarettes in the US, blu. It also has exposure to what remain relatively appealing tobacco markets in the Middle East, Europe and Asia.
However, when the impact of weaker sterling is factored in, I believe Imperial Brands is an even more likely takeover target. The pound has depreciated by 17% versus the US dollar since the referendum vote on 23 June last year. It is also much weaker than it was against a basket of currencies. It is therefore even cheaper for foreign peers who may be looking to deliver synergies and increase their financial strength in order to develop RRPs.
In my opinion, the pound will continue to weaken during the course of 2017 and 2018. I feel the talks between the UK and EU will not progress as constructively as many optimists believe, and a hard Brexit will become more likely. Therefore, confidence in the UK economy and the pound will worsen in my view. This could make Imperial Brands an even more appealing proposition for a foreign sector peer.
Outlook
Due to world population growth, the consumption of tobacco could increase in the long run. However, in the short term I believe cigarette volumes will continue to fall as price increases hurt demand, consumers become more health conscious and RRPs steal sales away from the more established sector. Therefore, I believe size and scale advantages make consolidation more likely over the next few years. The cost of R&D in order to develop RRPs compounds the appeal of M&A activity, since I feel e-cigarettes are the first in a long line of lower-risk products.
Imperial Brands offers good value for money in my opinion. I think its shares are fairly priced on a P/E of 15. The weakness of sterling makes them even more attractive to a foreign buyer, and I think this situation will be exaggerated as Brexit talks stall. Therefore, as well as buying Imperial Brands for its defensive characteristics, growth potential and fair valuation, another reason to be bullish on its prospects could be the chance of a bid approach over the medium term.