Scratching below the surface of tobacco companies

Philip Short

Consumers’ first thoughts on tobacco companies are generally “unhealthy; addictive; money machines”.

As an investor, one thinks “over reaching regulation; a dying industry; money machines”. Unenviable characteristics that one would prefer to avoid… except that money machine trait. That sounds interesting enough for us to scratch below the surface.

Regulation
Regulation is the biggest red flag when looking to invest in tobacco companies. Regulators dictate what products tobacco companies may and may not sell, and governments can increase taxes on tobacco products to the point where they become unaffordable. One of the more stringent regulators is the US Food and Drug Administration (FDA). This is a cause of concern for British American Tobacco (BATS) investors because the FDA has flexed their muscle over the tobacco companies of late, and forty per cent of BAT’s revenue is derived from the US.

How did the US become such a large percentage of BATS’ revenue? BATS used to own 42% of Reynolds American Inc. (the vehicle through which it had exposure to the US), and bought the remaining 58% in 2017. Why? The US still has a long runway of pricing power. Looking at where a box of cigarettes is sold worldwide in US$ versus GDP/capita, one can see that affordability still has far to go in the US.

Click here to read more...