Equity analysts are lowering their fair value estimates for three global large-cap tobacco manufacturers, after taking a less optimistic view of medium-term margins. Nevertheless, we still believe upside exists to the stocks, particularly Imperial Brands (IMB) and Philip Morris International (PM), and we think the group is heavily out of favour after heated tobacco sales suddenly plateaued in Japan in the first quarter of this year.
The catalyst, however, may not come until early next year when PMI commercializes its disposable heated-tobacco product. The high cost of the devices may be keeping some consumers on the sidelines, and we expect the late adopters to be enticed by some of the pipeline products that the tobacco manufacturers will bring to market in the next two to three years.
Specifically, we are lowering our fair value estimates for British American Tobacco (BATS) to £45 from £48, for Imperial Brands to £37 from £39, and for Philip Morris International to $102 from $104. We do not share the consensus view that tobacco margins will continue to expand over the next five years.
While evidence from Japan suggests industry volumes may be little affected by the adoption of substitute products, we are concerned that negative mix from vapor and devices and continued operating deleverage from declining volumes will be headwinds for earnings before tax margins in the medium term. Further, we are concerned that the migration of smokers to substitute products will spread volume across multiple product platforms, which will erode Big Tobacco's cost advantage and further constrain margin expansion.
We now assume relatively flat margins at roughly the 40% mark for all three companies, down from our previous assumption of margins rising gradually by around 2 percentage points over a five-year period.
The advent of e-cigarettes has created the most significant change in the 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 on the cusp of a seismic shift to next-generation products.
It seems likely that conventional tobacco will remain the driving force of the industry profit pool for at least the next decade, but big tobacco manufacturers are nevertheless placing their bets on the new categories most likely to win share of smokers.
