With plummeting consumption rates, disruption from new ‘vaping’ technologies and falling volumes, it is the beginning of the end for the lucrative tobacco industry, but analysts and income fund managers continue to bury their heads in the sand when it comes to the sector’s imminent decline. 
Near-term valuation yardsticks remain remarkably high despite a pronounced period of weakness for tobacco firms. Of the 19 sell-side analysts covering British American Tobacco none rate the stock a sell. Ditto for the 18 who cover Altria, owner of the Marlboro brand. This is remarkable for an industry that conceivably may not exist 30 years from now.
Market dominance
Historically, gradual declines in cigarette sales volumes have been offset by the industry’s unparalleled pricing power, leading to a growing profit tool. It is supported by the hugely addictive nature of nicotine, the consolidation of the industry, bans on marketing that protect the incumbents and the active discouragement of price competition by regulators.
Couple all of this with a fear of taxes soaring so high that an illicit trade forms that isn’t in the interests of bosses or tax-hungry government and you have an absurdly profitable, protected industry.
Altria, for example, has a hold over 50 per cent of the US cigarette market and enjoys a status as one of the most profitable listed equities of all time. According to Hendrik Bessembinder of Arizona State University, if you’d purchased its predecessor in 1926 and reinvested all subsequent dividends, you’d have made over two million times your initial stake. The 400 times the return you’d have made on Apple since its IPO pales in comparison.
Even the steady fall in smoking participation rates has done nothing to seriously dent profits in years gone by, tobacco stocks have continued to outperform thanks to the endless expansion of selling prices and margins.
Yet it is plain to see that this business model cannot continue forever. Smokers are increasingly ostracised, and participation levels are collapsing at a rate far faster than many have predicted.
Consumption continues to fall
Adult smoking participation rates in the US are now just 15 per cent and falling by about 50 basis points, or 0.5 per cent, each year. At the moment this is mathematically equivalent to a decline of just over 3 per cent per annum. The industry, and the bulk of the financial analysts who cover it, model this 3 per cent volume decline as sacrosanct, and historically this pace of decline has been easily recoverable via price.
This is a statistical mistake. A 3 per cent decline per annum suggests a slow, curved decline, asymptotically heading towards but never meeting zero. A 50 basis points per annum decline in smoking participation rate from a starting point of 15 per cent is equivalent to a 3 per cent decline today, but not once the smoking participation rate hits 10 per cent. Then a 50 basis points decline in the smoking participation rate is a 5 per cent volume decline. Once the participation rate hits 5 per cent, a further 50 basis points decline is a 10 per cent fall in volumes.
In this instance, the volume decline is no longer recoverable via price, and the longstanding model starts to break down. Is a 5 per cent smoking participation rate unrealistic? Not so, say the Scottish government, who are targeting a 5 per cent level by 2034.
Couple this with the growing evidence of disruption and profit pools run the risk of falling victim to new entrants.
‘Heat not burn’ technologies have rocked the market in Japan, where they have quickly taken 15 per cent share. Vaping technologies and brands, such as Juul in the US, continually get better. Consequently, tobacco volumes have started to plummet, data from Nielsen suggests US volumes declined over 5 per cent in the first quarter of this year alone. For big tobacco companies, this is no longer manageable.
The fact that something has happened for a long time doesn’t mean it can or will continue forever. The tobacco industry is reaching a tipping point, and investors who sensibly consider the long term should avoid it.
Julian Bishop is a global consumer analyst and income fund manager at Sarasin and Partners. The views expressed above are his own and should not be taken as investment advice.