FDA's Nicotine Plan Has Limited Impact on Big Tobacco
Even as smokers turn to substitutes, we expect continued industry domination.
The U.S. Food and Drug Administration has announced that it intends to lower levels of nicotine in cigarettes. We are fairly sanguine about the impact on tobacco manufacturers’ long-term cash flows, and we maintain our wide economic moat ratings and fair value estimates. Such measures are likely to accelerate the migration of smokers to substitute products, and we expect Big Tobacco to continue dominating the industry.
Although we do not believe the valuations of Altria (MO) and British American Tobacco (BTI) have been impaired by the high-single-digit amount implied by the market’s reaction, we have regarded both companies as being substantially overvalued for some time, and the correction brings the market prices more into line with our fair value estimates.
Some of the manufacturers whose market capitalization remained more robust in light of this development, including Philip Morris International (PM), remain overvalued, as we think the market has become too bullish on the margin opportunity presented by next-generation products.
We expect the FDA’s intended measures to curb nicotine to be a multiyear process and for their impact to take even longer. While some consumers may smoke more frequently to maintain their nicotine intake, we expect the net impact to be negative on industry volume, because some smokers may be weaned off their nicotine habit and find it easier to quit, and others may become dissatisfied with cigarettes as a nicotine delivery mechanism, turning instead to the range of alternative products now available.
Of those alternatives, we think the heated tobacco category is best positioned to capture the migration of smokers from combustible cigarettes. Within the category, Philip Morris and Altria have stolen a march on their competitors and have submitted an application to the FDA to commercialize a product in the United States. All of the major tobacco manufacturers have a presence in vaping, a nontobacco category that has been the primary driver of e-cigarette growth to date.
Our objection to current valuations in the tobacco space revolves around the financial impact of this migration to reduced-risk products and the competitive advantages of being an incumbent in the emerging categories. The market is giving a valuation premium to those companies with the most exposure to heated tobacco. Philip Morris International, the global category leader, is trading at almost 22 times 2018 earnings; British American Tobacco, which is playing catch-up and recently launched its heated tobacco product in Japan, trades at 16 times; and Imperial (IMBBY), which has so far abstained from investing in the category, is trading at under 12 times adjusted 2018 earnings. This unprecedented valuation range seems to imply two things: (1) The heated tobacco category will generate higher levels of free cash flow than the combustible business and (2) most of the benefits will accrue to the first mover. We take issue with both of these implications.
In the most bullish scenario, heated tobacco could generate even higher margins than the 40% currently generated in conventional cigarettes. If the sticks realize the same retail price as a pack of cigarettes, and if excise taxes are levied at a more favorable rate than on traditional cigarettes, then a greater proportion of the retail price would flow to the manufacturer’s bottom line. Under these conditions, and at scale, we believe margins would be at least as high as those for conventional premium cigarettes, but we think this outcome would only occur if governments were willing to facilitate smokers switching to heated tobacco, which in turn would probably only occur in light of independent evidence of reduced risk. However, the FDA’s actions show that there are means beyond the retail price of facilitating that migration, and we still expect governments to extract their pound of flesh from the tobacco industry in the form of high excise taxes. This scenario is reflected in our bull-case scenario for Philip Morris International, in which we assume a multimarket migration to IQOS, driving 7% growth for the next four years and a midcycle EBIT margin of 47%, well above today’s 41%. This scenario yields a fair value estimate of $123, only marginally above the current price, implying that the market is pricing in a very bullish scenario.
Another reason for caution on profitability expectations is the effect of incoming competition into the category. While PMI has invested $3 billion in the category and is in trial markets across the world, its competitors are only just getting their act together. British American Tobacco and Japan Tobacco are in the early stages of commercialization in Japan. The entry of BAT’s Glo in Tokyo has resulted in PMI introducing price discounts on its IQOS device, with the latest device, IQOS 2.4, reduced in price from JPY 10,980 to JPY 7,980. At full price, we believe the devices have modestly negative margins, and in a more competitive market, we would not be surprised to see the category evolve into a razor-and-blade model, with the high margins of the sticks being tempered by highly competitive pricing on the devices.
While the market is valuing tobacco manufacturers according to their current exposure to heated tobacco, we see only limited first-mover advantage among the multinational players. Barriers to entry to the tobacco industry are high, and as a tobacco product, heated tobacco will be regulated in most markets under the restrictive production and selling rules that govern the cigarette industry. Although this will establish too high a barrier for new entrants to gain traction, we think it is entirely possible for cigarette makers such as Imperial to take share. In fact, we think the FDA’s announcement on nicotine makes this likely sooner rather than later. Cigarette manufacturers leverage proprietary databases to market directly to adult smokers, and they have the research and development budgets to bring a product to the commercialization stage fairly quickly. We expect a four-firm heated tobacco oligopoly would reflect the fairly rational competitive dynamics of today’s cigarette industry, and we anticipate price competition being largely limited to the devices.
We think the FDA’s announcement makes a recombination of Philip Morris International and Altria incrementally more likely. We think an acquisition would make strategic sense for PMI, particularly as the companies are cooperating closely on the development and application for the commercialization of IQOS in the U.S., and an acquisition of its sister company would reduce the currency exposure that has dogged PMI’s reported financial performance for several years. Nevertheless, for a cash-financed acquisition, we would prefer to see a further pullback in Altria’s market value for PMI to be able to create value.