In a surprising move, Big Tobacco, represented by British American Tobacco Plc, anticipates a £25 billion ($31.5 billion) charge, acknowledging a grim future for traditional cigarette brands like Camel and Newport. The tobacco giant is signalling a strategic shift, aiming for reduced-risk products to constitute 50% of revenue by 2035. With rivals like Philip Morris International Inc. also steering toward alternatives, the industry faces challenges in a declining cigarette market and regulatory uncertainties, testing the viability of a smoke-free future while maintaining shareholder returns.
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Even Big Tobacco Resolves to Finally Quit Smoking: Andrea Felsted
By Andrea Felsted
It’s not even Christmas, and the new year’s resolutions to give up smoking are coming in thick and fast — this time from Big Tobacco.
British American Tobacco Plc last week said it would take a £25 billion ($31.5 billion) charge for reducing the value of its US cigarette brands Camel, Newport, Natural American Spirit and Pall Mall.
Although non-cash, the scale of the writedown is striking. Analysts have predicted that in many markets there would be no smokers in 10-20 years time, and governments, including the UK, have taken steps to make this happen, but the announcement is the clearest indication yet that the tobacco industry thinks the same. In developed markets, smoking is expected to shrink significantly within decades if not essentially die out.
Unfortunately, there are side effects from quitting.
Up until now, BAT has assumed that the brands — which came onto its balance sheet after it bought the shares in Reynolds American Inc. that it didn’t own six years ago — would continue to exist indefinitely, because smoking would remain prevalent. Now, it’s decided that these assets have a lifespan of 30 years — roughly when it assumes smoking will fall to a small part of its US business.
BAT wants so-called reduced-risk products — electronic cigarettes, devices that heat rather than burn tobacco, and oral nicotine — to be 50% of its revenue by 2035, compared with 15% in 2022. This is another reason for the writedown. It can’t bet on a smokeless world while expecting this to have no meaningful impact on cigarette sales.
The company isn’t alone in trying to kick the habit. Rival Philip Morris International Inc., which sells Marlboro cigarettes outside of the US, wants more than two-thirds of its net revenue to come from potentially reduced-risk products by 2030, compared with about a third today.
The theory goes that in developed markets, demand for cigarettes falls gradually each year — but that Big Tobacco can counteract this using its still prodigious cash generation to invest in a suite of alternatives. Now this outlook is being upended.
Before the pandemic — which saw smoking increase as people worked from home and lit up more regularly — the US cigarette market was declining by 4%-5% a year, according to BAT. The fall this year could be about twice that rate because of pressure on US incomes, as well as the availability of illicit, primarily disposable vapes. Euromonitor International estimates that US cigarette volumes could drop by more than 30% from their 2020 high by 2027.
At the same time, introducing potentially reduced-risk products has been far from straightforward. If anything exemplifies the industry’s struggles, it is Altria Group Inc.’s disastrous investment in vape-maker Juul Labs Inc., which was hit by lawsuits accusing it of targeting underage users with sweet fruit and candy flavors, and whose products could be banned in the US.
Now it’s mostly disposable vapes that are the problem. These have not gone through the rigorous FDA permission process yet remain on the market. And regulatory risks to cigarettes have not gone away either. BAT faces a potential ban on menthol cigarettes in the US, which account for about 45% of BAT’s US business, according to Duncan Fox of Bloomberg Intelligence.
Meanwhile, as Big Tobacco builds its future, investors won’t want to be left out. They’ll continue to demand that a significant proportion of the cash still generated by cigarettes is distributed to them through dividends or buybacks.
So what do shareholders need to see to accept the long-term scenario, whereby cash is cycled into alternatives, and that these products generate profits rather than just drain cash?
The first is that the current sharp fall in US demand for cigarettes stabilizes. US inflation is coming down, but if anything, it looks like the US consumer is beginning to buckle. So this scenario looks unlikely.
The second is that US regulators help stem the flow of illicit disposable vapes. The FDA is currently in the process of assessing whether e-cigarette makers can keep their products on the market. When this is complete, it could step up enforcement action against manufacturers operating without its permission. But this can’t be taken for granted either.
Finally, shareholders must believe that investment in alternatives can pay off. Here, despite the struggles, there are some grounds for optimism.
Philip Morris bet early on its heat-not-burn device IQOS, which is the market leader by some way, currently generating $10 billion of annual revenue. IQOS may get a further boost in 2024 when it launches in the US. In 2022, PMI also acquired oral nicotine pouch maker Swedish Match for $16 billion, giving it a second leg in alternatives.
PMI moving closer to becoming smoke-free — as well as the fact that it has no exposure to the US traditional cigarette market after it was spun out from Altria in 2008 — explains the 27% premium on a forward price-to-earnings basis to Bloomberg Intelligence’s global tobacco peer group.
True, the company has hit speed bumps. It will take a few more quarters to reach its goal of 50% of sales from alternatives by 2025. And in 2021 it acquired inhaler-developer Vectura Group Plc. — but after a disappointing drug trial, it took a $680 million non-cash impairment charge. It doesn’t split out the returns from its non-cigarette business, but it has consistently said that they are more profitable than cigarettes, although right now it’s in a heavy spending phase.
BAT also said it expected its alternatives arm to break even this year, although it added that the performance of its Glo heated-tobacco device, number two after IQOS, has been disappointing, and it would need to pump in further investment.
Giving up cigarettes won’t be easy, but it’s clear the tobacco industry has little choice. Still, it must do so without its shareholder returns going up in smoke.
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© 2023 Bloomberg L.P.
