Pieter Vorster currently covers the European Tobacco sector for CSFB in London. He has been with the company since it acquired Donaldson, Lufkin & Jenrette in 2000 where he was responsible for covering European Tobacco as well the South African Diversified Industrial sectors.
Prior to that he was an analyst at UBS Warburg and ABN Amro in South Africa.
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Tobacco is a controversial industry.
Over the last 20 years , tobacco has become an increasingly controversial industry as the health risks associated with smoking lead to governments applying increased levels regulation and taxation . At the same time a strong anti-smoking lobby has developed and litigation against the industry has increased. As such, investors in the tobacco sector have had to become accustomed to dealing with a substantially higher level of extraneous factors when compared with other consumer staple industries.
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Cash flows and earnings are fairly predictable.
One of the main characteristics of the tobacco industry is its strong and predictable cash flow. This means that tobacco companies are not reliant on share issues to grow and reduces the impact of share price fluctuations on the longer- term prospects of the industry.
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Litigation and regulatory newsflow are not predictable.
As predictable as tobacco cash flows are, as unpredictable are newsflow relating to litigation and new regulations. Often, rational expectations of the outcome of a court case, particularly in the US, are met with sometimes unreasonable rulings in regional courts. Although most of these rulings are normally overturned in higher courts, they cause substantial uncertainty among investors in the sector.
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Valuations are sensitive to news flow.
Over the last ten years virtually all the major share price movements in this sector have been related to litigation events. These events have introduced a large degree of volatility into the sector, which under normal circumstances would have been regarded as a stable low growth industry. As such, investors in tobacco stocks need to constantly monitor potential litigation and regulatory events, as these invariably have a substantial impact on stock price performance, as irrational as it may seem.
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Traditional DCF valuations can be misleading.
Because of the combination of strong and predictable cash flows and unpredictable newsflow, traditional discounted cash flow models will almost always suggest that tobacco stocks are undervalued. However, investors need to adjust these DCF values with a litigation discount, depending on the specific litigation exposure of the stock. In doing so investors can identify when the implied litigation discount becomes excessive. In the past this has provided attractive buying opportunities.
Conversely, when virtually no litigation discount is implied in a share price, the stock would be vulnerable to adverse litigation and regulatory newsflow.
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Be wary of earnings disappointments.
Profit warnings and earnings disappointments are rare among tobacco companies due to the predictable nature of the business. When they occur, they are often a sign of underlying problems in the company and should be investigated thoroughly. Stocks with repeated earnings disappointments are best avoided, even if they trade at a discount to their peers.
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High levels of regulation are not necessarily negative.
Countries with high levels of regulation do not necessarily have low levels of cigarette consumption. Often the regulation acts as a barrier to entry and protects producers with already strong positions in these markets. However, markets that experience rapid increases in regulation and excise taxes will more than likely experience volume declines for a number of years. Following this period of initial decline, volumes generally stabilise.
Markets most at risk are those which have low levels of current regulation, but in which pressure for increased regulation is building. The EU accession countries are a good example of this.
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International brands are growing faster.
Whereas global cigarette volumes are recording only marginal growth if at all, international brands are growing at an underlying rate of some 4-5% p.a.. This is an important source of growth for the industry and a trend that generally favours multi-national producers with strong brands.
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Demographic factors are important.
Just like in any other consumer sector, demographics play an important role in the growth or lack of growth in the tobacco industry. On a country-by-country basis, population is the most important determinant of cigarette volumes. Those markets that are expected to experience growth in their young population are potentially attractive growth markets for cigarette manufacturers, whereas those with aging populations can generally be regarded as having unattractive volume growth potential.
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Don't forget about pricing.
Whilst volume growth is important when evaluating the performance and potential of a cigarette producer, price growth is a more important determinant of profitability. This is because demand for tobacco products is relatively price inelastic. The most important determinant of global cigarette prices is per capita income and markets where this is expected to grow are those with potential price growth potential. In addition, producers who are able to command premium prices for their products in these markets stand to benefit more.
