Tobacco stocks such as FTSE 100 listed British American Tobacco (BATS) and Imperial (IMB) have moved sharply downward in recent days after the US Food and Drug Administration proposed a ban menthol in cigarettes, a limit on the marketing of flavours in vaping liquids, and a ban flavoured cigars.
This represents the most concerted attempt to clamp down on the tobacco industry in 20 years. But Morningstar analysts believe the stock market in pricing in a worst-case scenario for the cigarette manufacturers.
Even if the FDA does bring into force a menthol ban, we think the effects of such a development are already more than priced in. Our analysis shows that the market reaction is proportionate to an unlikely outcome whereby all industry menthol volume is lost immediately after prohibition. We expect a less extreme outcome, with some volume decline but some volume migration to non-menthol variants within brand families.
In this scenario, we believe the market has overreacted to the news and has dragged down some already undervalued stocks to very attractive levels. Having said that, the potential menthol ban will now act as a new overhang over the stocks, and it may take more than a rebound in heated tobacco to deliver the upside we believe is on offer at today's prices. Investors will have to be patient and have the stomach for further fat-tail risk, but we think British American Tobacco and Imperial Brands are all trading at attractive margins of safety.
What Would Menthol Smokers Switch To?
If menthol smokers switch to nonmenthol, it is possible that the bulk of consumption would be captured by the cigarette manufacturers. Most offer a regular tobacco alternative under the same brand umbrella and would likely retain most of the volume under threat from a menthol ban. British American Tobacco’s Newport brand has a non-menthol variety, as Imperial Brands may face the largest volume risk, as Kool does not have a non-menthol variant, but we believe the company is likely to be able to launch one under the substantial equivalence rule. Logically, if menthol is banned because it is a greater danger to public health, then a non-menthol version of the product with a similar tar level and tobacco blend would most likely meet the substantial equivalence test of causing no more questions of public health.
It is the ease of initiation to smoking that the FDA now appears to be targeting, and all three proposals are being framed around initiation, particularly amongst youth. The only surprise about the FDA's proposals to restrict the marketing of vaping flavours is that these measures weren't brought in sooner. It has long been our assertion that freely available flavoured liquids, particularly in the online channel, would attract regulatory scrutiny because of the likelihood that they would be purchased and consumed by nonsmokers and young people in particular.
We think the tobacco manufacturers have little to lose and possibly something to gain from the proposed tighter restrictions on vaping flavours. Vaping is currently a negligible component of the revenue of most of the large-cap cigarette makers. We estimate that vaping represented just 1% of BAT's top line in the first half of 2018, around 3% of Imperial Brands' revenue in the financial year ended 30 September. We do not believe any of the large cigarette makers are profitable in vaping at present, although the category may be a modest boost to Imperial's pre-tax profits next year.
