Mark Barnett: Tobacco sector will face up to its challenges

Mark-Barnett-Invesco-Perpetual-2013.jpgFollowing the initial reaction to the outcome of the EU referendum, the UK stockmarket will remain influenced by a muted macro backdrop globally and an increased pressure on profitability in the corporate sector. The global economy faces an ongoing lack of pricing power, which has restrained the level of turnover growth in many industries.

Against such a backdrop, the tobacco sector remains an attractive area to invest, with its potential to deliver earnings and, in particular, dividend growth.  Despite its well-publicised headwinds, including most recently the introduction of plain packaging, the sector has performed strongly over the past 24 months.

This period has also encompassed the merger of two of the top three tobacco companies in the US, with Reynolds American – number two to Philip Morris – cleared to acquire the number three player Lorillard.

British American Tobacco supported the deal to the tune of its 42 per cent shareholding in Reynolds American, while Imperial Brands acquired a portfolio of brands such as Winston, and infrastructure including Lorillard’s factory, national sales team and marketing resource. The deal, which offered the scope for major synergies, has proved significantly earnings enhancing for both Imperial Brands and Reynolds America – and therefore indirectly to British American Tobacco.

UScigarettetables

Another positive for the sector over the past year has been the improving trend in US cigarette volumes and pricing. Figure one shows how the previously inexorable decline in cigarette volumes has now flattened out in the relatively mature US market.

Meanwhile, and against a backdrop where few companies or industries have pricing power, US cigarette prices are showing a healthy upwards trend.

Looking outside the US, emerging markets also offer the scope for volume growth, notably for British American Tobacco. Emerging markets may have proved challenging of late for sales of many consumer goods, but cigarette sales have continued to rise.

An increasingly global market should also benefit international brands at the expense of local brands. International air travel, with duty-free sales, along with rising wealth, is generally expected to drive a switch from the consumption of the local brand to these global brands. Figure three shows the volume trend for British American Tobacco’s international brands in emerging markets.

But what about the aforementioned headwind of plain packaging? Imperial Brands appears to have shown there “is a way through plain packaging”, with rising volumes of its JPS brand in Australia since its introduction over there. Headwinds will prevail for this sector but one advantage of this is that there are no new significant entrants to the industry. The companies’ combined focus on cash conversion and cash returns to shareholders continues to make them attractive holdings.

Mark Barnett is head of UK equities at Invesco Perpetual