Most industries have a single factor that helps investors to understand them better. Unfortunately for investors looking for easy wins, it does not necessarily help to figure out what these factors are, as their future state is often unpredictable. Ruan Stander takes a look at some of the factors that define various industries, focusing on what makes tobacco economics attractive to today's shareholder.
Realising what is important does not make a company's performance predictable
To understand the economic prospects of many manufacturers, for example, requires an understanding of industry capacity and future supply. But this is quite complicated, as there are so many different factors that need to be taken into account when estimating future supply. The lowest cost producer of items can change as low labour cost countries open up and develop. Changing manufacturing technology has the potential to render existing equipment worthless. Counter-intuitively, growth can diminish the advantages of scale since scale economies drop off at some point and a large enough industry makes it easier for new companies to start. So, while it may be simple to identify future supply as the single most important factor in understanding a manufacturer, the outcome is not necessarily predictable.
Financial companies are another good example: understanding downside risk (the impact of a bad outcome) is crucial to building an investment case. But this is also harder than many would think, as we witnessed during the global financial crisis and, for those who were not paying attention, the European crisis is driving the point home. A combination of complex organisations with many layers of management can humble even the companies that say all the right things about downside risk.
Resources companies require an understanding of the cost position of resources in the ground relative to competitors. Geologists set up resource statements that should give investors an idea of the amount of resources recoverable at a reasonable cost. However, industry veterans can point to many companies that misled 'informed' investors about the quality of their resources. On top of this, pricing cycles tend to last longer than investors think and technology can increase supply (and decrease prices) in a short period of time. Who would have thought the Americans would target an energy surplus in 10 years' time?
Fortunately for the tobacco investor, the most important factor is understandable and to an unusual extent predictable.
A COMBINATION OF ADVERTISING BANS, INCREASED EXCISE TAXES AND BRAND-LOYAL CONSUMERS CREATES A MONEY-MAKING MACHINE THAT KEEPS ON GIVING TO SHAREHOLDERS AND, IMPORTANTLY, GOVERNMENTS TOO
Tobacco economics is attractive because of the role that a rational government plays in facilitating a larger profit pool. A rational government wants to maximise tax revenue while reducing the health impact of smoking on its citizens. The most effective method of achieving both is to tax tobacco heavily and hope that the high prices will result in less smoking.
A combination of advertising bans, increased excise taxes and brand-loyal consumers creates a money-making machine that keeps on giving to shareholders and, importantly, governments too. Increased excise taxes facilitate higher cigarette prices (other industries require collusion to achieve this), smokers keep on smoking despite higher prices and advertising bans make it very difficult to get brand-loyal smokers to switch to new brands without incurring substantial losses. This allows a tobacco company to earn a low net profit margin of approximately 7% of gross revenue (versus 70% in total taxes collected by tobacco companies on government's behalf) on an inflation-beating retail price of cigarettes.
Table 1 illustrates the history that supports this argument by looking at the growth rate of volume, price and revenue of cigarettes in three developed countries.
Some observations from Table 1:
- Volumes declined over time, but
- Tobacco prices increased faster than the country's wealth (GDP)
- The net effect was that the industry revenue pool increased faster than most anticipated
Despite volumes declining by 1.4% per year on average, real industry revenue grew at two-thirds of real GDP (1.8% versus 2.7%). The fact that tobacco companies do not have to invest in new products to increase real prices, or in new capacity to grow volumes, more than makes up for the slightly lower growth. A quick calculation illustrates this best:
Assume you buy a tobacco company and an average company at 15 times earnings (a 6.7% earnings yield) each. You can expect the tobacco company to return 8.5% (1.8% real growth + 6.7% in dividends) in real terms. The average listed company in South Africa pays out half of its profits as dividends and reinvests the balance to fund growth. Therefore, an average company's return will give you only 5.1% (2.7% real growth + 6.7% x 0.5 in dividends).
Table 2 illustrates how the above economics translated into superior returns for shareholders by showing the returns British American Tobacco (BAT) shareholders earned over and above the South African market.
Plain packaging proposals
Unfortunately, few investment lunches are free and the most recent threat to tobacco shareholders is 'plain packaging'. The idea behind plain packaging is that if it is the brand that gets people to smoke, taking away the last visual image of a brand may help to reduce smoking. This was proposed in Australia and, despite the threat of legal action from tobacco companies, it seems likely that the regulation will be implemented this December. Most attempts to decrease smoking through regulation have succeeded, but they have also indirectly sustained the 'money-making machine' economics described above. One would be foolish to dismiss a new threat simply because of the limited impact of previous changes. Nevertheless, at this stage we expect the potential impact of the Australian changes on BAT's global earnings to be low.
BAT REMAINS AN ATTRACTIVE INVESTMENT FOR OUR CLIENTS PORTFOLIOS
In our view, three things would need to happen for BAT's earnings to be affected significantly by plain packaging regulations:
1. The regulation needs to be legal
Tobacco companies claim that plain packaging steals your brand and are ready to defend this in court.
2. The regulation needs to be effective
No evidence is available that supports the effectiveness of this regulation. On top of this, the regulation might stimulate the counterfeit market that would reduce effectiveness.
3. Many other countries would need to copy the regulation
BAT operates in more than 100 countries. One could argue that political wins are less clear for plain packaging than smoking area bans. The government also needs to weigh up the expected decrease in taxes.
BAT is trading on 16 times expected 2012 earnings. This is the same as the market's PE on our estimate of bottom-up normalised earnings. In our view, the history of tobacco economics and the fact that a large portion of BAT's cigarette sales come from countries with low prices more than offsets the regulatory risks and BAT remains an attractive investment for our clients' portfolios.