"I'll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It's addictive. And there's a fantastic brand loyalty." - Warren Buffett (1987)
Although Mr Buffett is thought to have some reservations about the issues facing the tobacco industry, there’s no doubt that this quote captures the innate quality of Big Tobacco, from an investment perspective.
FTSE 100 member Imperial Tobacco has delivered a 136% total return for shareholders since 2009. A capital gain of 97% has been topped up with a generous dividend payout that’s risen by an average of almost 10% per year.
Tobacco firms like Imperial have proved that advertising restrictions, constant tax hikes and a thoroughly dangerous product are no barrier to financial success.
The addictive nature of tobacco helps, of course. A cynic might even suggest that the tax hikes help too, as they enable tobacco firms to slip through their own price increases under the cover of a rise in tax...
What’s really happening?
The reality is that the tobacco industry is seeing a structural decline in sales.
My calculations suggest that Imperial’s tobacco volumes have fallen by an average of 2.8% per year since 2009. Total volumes have fallen by 18%, from 347bn stick equivalents in 2009*, to just 294bn in 2014.
The tobacco industry is responding to this change by consolidating and focusing on fewer brands. Imperial’s marketing is focused heavily on its portfolio of ten growth brands, from which revenues are rising.
In June, the group completed the acquisition of a number of US cigarette brands owned by Reynolds American and Lorillard. These assets were being divested as a result of the merger of these two firms, one of which (Reynolds) is part-owned by British American Tobacco.
Concentrating ownership in this way and reducing the number of brands to a relatively small number of widely-recognised premium brands has paid dividends. The adjusted operating margin of Imperial’s tobacco business was 43.3% in 2014, up from 42.9% the previous year.
Full-year profits for 2015 are expected to be 40% higher than last year.
Still good value?
After such an impressive performance, you wouldn’t expect Imperial stock to be cheap. Yet the shares don’t look expensive and have qualified for the James O’Shaugnessy Cornerstone Value Screen since January 2013.
Imperial’s ValueRank of 69 would be…
