Tobacco Primer - C S
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Tobacco bond primer
Transcript of Tobacco Primer - C S
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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION
Client-Driven Solutions, Insights, and Access
24 March 2014
Europe
Equity Research
Consumer Staples (Tobacco)
Tobacco THEME
Industry primer We transfer coverage of Philip Morris International (maintain Neutral, TP
US$85), British American Tobacco (downgrading to Neutral, new TP
3,500p) and Imperial Tobacco (maintain Outperform, new TP 2,700p) to our
European Consumer Staples team.
After a decade or more of little/no volume growth, the past five years have
seen global tobacco volumes (ex. US/China) decline. Most markets have
seen growth rates slow meaningfully; the global declines in each of the past
five years have been worse than in any of the previous 10.
Several reasons can explain this, some of which are cyclical (pressure on
disposable incomes, increased unemployment) while some might be
considered more structural (illicit trade, renewed focus from authorities,
higher excise duty hikes, advances in new technology).
The higher rates of excise duty are, however, a double-edged sword. While
this puts pressure on market volumes, it is price that has always been the real
driver of industry margins/returns. The industry has been able to take
advantage of government-induced inflation, which has been highly profitable.
The past few years have also seen the highest levels of pricing by the industry.
Thus the past five years have been characterised by weaker volumes, but
the higher pricing has helped industry margins up to record levels; the
industry has seen particularly strong increases in margins.
We believe the markets will return to their previous, rather more steady
declines (rather than the steeper falls of late), although not for a year or so.
Then there is new technology. The media coverage far outweighs the reality
e-cigarettes are still a very small part of the market and data show a
levelling-off in sales recently. Many smokers have been willing to try the
products, but technology still has a long way to go for e-cigarettes to have a
big impact on tobacco sales. That is not to dismiss the threat/opportunity it
could undermine the current brand franchises like any new technology but
we believe the tobacco giants will dominate the new industry whatever its
size. Industries in long-term decline also have a habit of consolidating,
especially when integration yields major benefits. Press reports suggest
some US consolidation is possible (FT 03/03/14). In due course we expect
the Big 4 global players (PMI, BAT, IMT, JT) could become the Big 3.
Figure 1: Tobacco: Ratings and TPs Rating Ticker CCY Share price Target price Up-/downside 2014 PE EV/NOPAT Div yield
British American Tobacco NEUTRAL BATS.L GBp 3215 3500 9% 15.4x 15.1x 4.5%
Imperial Tobacco OUTPERFORM IMT.L GBp 2418 2700 12% 11.5x 14.1x 5.4%
Philip Morris International NEUTRAL PM USD 80.4 85.0 6% 15.6x 17.5x 4.7% Source: Credit Suisse estimates
Research Analysts
Jimmie Bork
44 20 7883 9941
Charlie Mills
44 20 7888 0325
Pieter Vorster
27 11 012 80 64
Nicolas Sochovsky
44 20 7883 8075
Alex Molloy
41 44 333 05 83
Sanjeet Aujla
44 20 7888 0353
Kieran McGrath
44 20 7888 9216
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24 March 2014
Tobacco 2
Key charts: The story in brief Figure 2: Market volumes have deteriorated since 2008 Figure 3: but pricing has been strong
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
TMA Euromonitor Top 4 tobacco
-4%
-2%
0%
2%
4%
6%
8%
10%
Retail sales (cc) Volumes Pricing
Source: Euromonitor, Company data, TMA Source: Company data, Thomson Reuters
Figure 4: Price/volume relationship consistent with
history
Figure 5: Pricing always better for industry margins
1999
20002001
2002
2003
200420052006
20072008
2009
2010
2011
2012
R = 0.8444
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
0% 2% 4% 6% 8% 10%
Vo
lum
e g
row
th
Price/mix (constant currency)
Elasticity 0.3-0.5
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
Source: Euromonitor (Cigarette + OTP) Source: Aggregated margin of BAT, IMT, PMI and JT
Figure 6: e-cigarette sales look to be maturing (US data) Figure 7: Declining industries consolidate
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Retail sales (m USD) Volume (m units, RHS)
50%
55%
60%
65%
70%
75%
80%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Top 4 tobacco % international market (ex China, USA)
JT: Gallaher
IMT: Altadis
BAT: STG, Tekel
PMI: Fortune
Source: AC Nielsen data for the US Source: Euromonitor
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Table of contents Key charts: The story in brief 2 New world, new reality? 4
Background 4 So what has happened to industry volumes? 7
1: Increased levels of unemployment 9 2: Decline in disposable incomes 10 3: Excise duties have risen at a faster rate in the past four years 11 4: Illicit trade has increased significantly 12 5: The rise of e-cigarettes 14
New technology 15 Availability 16 Technology 16
What comes after e-cigarettes? 18 Regulation 19 Tax 19 US market the test market for e-cigarettes? 20
Will tobacco companies win this market? 21 Profitability 22 Summary 22
Prospects where to from here? 24 Economic indicators improve? 24 Excise duty pressures 24 Illicit trade a structural issue 27 Credit Suisse outlook 27
Industry consolidation 28 Possible US/China entry? 31
China 31 US 31
Possible Top 4 merger? 32
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Tobacco 4
New world, new reality? Has the long-term dynamic of the tobacco industry gone through a structural change?
Or a blip?
Are e-cigarettes pivotal for the industry?
We think that based on the past five years trading alone, the first is a reasonable question
to ask. Market volumes/pricing over this period are in stark contrast to the preceding
years. New technology (e-cigarettes) validates this question further. History is generally a
good guide to the future in consumer staples, but is it thus for the tobacco industry?
Background
It is surely not courting controversy to declare that smoking tobacco is perceived as a
dying habit, be that a statement on the health implications, or simply a comment on
consumer trends.
Historically, the global market (and here we exclude the US and China) was actually
showing little or no growth depending on which data source one preferred to use.
Euromonitor shows small growth, TMA a small decline, while for the Top 4 tobacco
companies, organic growth was slightly better. We exclude China and the US for two
reasons:
The sheer size of the Chinese market (almost half of global volumes) distorts the
international market.
The three major international producers, which are the subjects of this report, do not
operate in either of these countries.
Since the financial crisis, all sources agree that volume growth has been c2% lower than
before. At the same time pricing has been higher than ever before. It might reasonably be
argued that not much has changed a slightly higher pricing more than offsetting the
weaker volumes. However, there is more to it than that.
It is important to recognise at the outset that pricing relates to retail prices (including
retailer mark-up and excise duty), not the manufacturers' selling prices.
Figure 8: Global market (excl. China and US) volume
growth, 2000-2013
Figure 9: Growth in tobacco market (retail selling prices)
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
TMA Euromonitor Top 4 tobacco
-4%
-2%
0%
2%
4%
6%
8%
10%
Retail sales (cc) Volumes Pricing
Source: Euromonitor, TMA, company data Source: Euromonitor
Since 2008 industry volume
growth has slipped by
200bps.
Weaker volumes. but
higher pricing has kept
organic growth at similar
levels
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Tobacco 5
The role of price in this industry is crucial to not just the manufacturers, but also to retailers
and especially governments. Declining volumes have not proved an impediment to the
tobacco companies' growth (their EPS comfortably exceeding that of other staples over
the past decade). Although industry consolidation has played a part (we discuss this again
later in the report), it is the unique selling architecture of the industry that drives the top
line (as we see above) and also (importantly) profits.
Figure 10: Global revenues (ex. China and the US) industry has defended its share of
the profit pool by keeping the same proportion of retail sales over time
66%66%
67%
12%
12%
11%
22%
22%
22%
0
50
100
150
200
250
300
350
400
450
2005 2008 2012
Taxes Trade Manufacturers
$413bn
$294bn
+6-7% organic CAGR
$361bn
Source: PMI data
As governments raise tobacco taxes, the industry typically matches them with price
increases of its own this is a generalisation, but over the past eight years as the value of
the market has risen 6-7% per annum, the industry's take of the final selling price has not
changed, according to data presented by PMI.
As the manufacturers take is only c20% of the final selling price, a 5% rise in price by the
producer only equates to a 1% rise for the final customer, all else being equal a novel
feature for tobacco among staples companies. Even in spirits the manufacturer has a little
over half of the final retail selling price.
Figure 11: Net sales as a % gross sales suggests that retail pricing has been marginally
more than the manufacturer's pricing
30%
32%
34%
36%
38%
40%
42%
44%
2005 2006 2007 2008 2009 2010 2011 2012
PMI BATS
Source: Company data. Gross sales are net of sales/promotional incentives. Net sales also exclude excise
Pricing has always been the
key metric in this industry
The tobacco industry has
been adept at raising prices
to pass on excise price
increases
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Tobacco 6
The accounts of the major tobacco companies tell a slightly different story. Consider the
net revenue (i.e. ex taxes) as a percentage of the gross revenue (i.e. including taxes) of
the major players over the past eight years. Geographic trends/mix, acquisitions and
restrictions on trade promotion will have played a part, but both BAT and PMI have seen
their net sales fall as a percentage of gross sales (so taxes have gone up more than
manufacturers' selling prices). We exclude IMT due to significant M&A (notably Altadis)
distorting the comparatives (Figure 12).
The correlation with government excise duty increases has meant that industry pricing has
been, and looks set to remain, strong. For the three large Europe-based companies, price
has averaged 5% per annum for the past eight years (and over 6% for the past four years)
against, by way of illustration, just over 2% for other staples sectors.
Figure 12: Price a greater contributor to top line growth for tobacco relative to staples
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
2005 2006 2007 2008 2009 2010 2011 2012
Staples Tobacco Staples average Tobacco average
Source: Company data (IMT, BATS, PMI), Credit Suisse research
Price is not only the single largest contributor to top-line growth, but it also accounts for
over 100% of the profit growth. PMI each year breaks out the components of its profit
growth below we simply aggregate the past seven years' data to illustrate the
importance of price to PMI, the industry leader.
Figure 13: Tobacco profit growth it's all in the price PMI case in point
8,350
13,493
11,394
506
1,958
2,763
1,024
5000
7000
9000
11000
13000
15000
17000
19000
21000
2006 EBIT Price Mix Volume Investment FX, M&A, other 2013 EBIT
PM
I E
BIT
contr
ibution (
US
Dm
)
220% of
profit growth
Source: Company data
Raising prices with
government price hikes has
been highly remunerative for
the tobacco industry
Price the key driver of profits
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Tobacco 7
So the past five years may have been characterised by weak volumes and higher prices,
but it is the latter that is more important to profits. For all the pressures on volumes
industry margins have proved particularly strong over the same period, the increases far
outstripping what had come before.
Figure 14: Aggregated margin of the Top 4 tobacco companies
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
"Big 4"
"Big 4" ex JT
Source: Company data, Credit Suisse estimates
While we believe the market is aware of the facts, it is important to set the ground rules
and the extent to which this industry relies on price.
However, pricing is a double-edged sword, while it is (very) good for profits, it can, and
does, put continued stress on industry volumes. Each price hike or excise increase is
accompanied by another lurch-down in consumption industry volumes. The elevated
pricing of the past four years, as excise duties have picked up, has put additional stress on
cigarette volumes (Figure 9).
So what has happened to industry volumes?
Figure 8 and Figure 9 indicate that the level of pricing has gone up more, and so volumes
have suffered. However, this is only a part of the picture. A closer look at the volume
softness points to EEMA and EU (Figure 16 shows the volume trend pre-2008 vs post-
2008). Growth rates in Asia-Pac and the Americas have not really changed.
Price elasticity very
apparent so past five
years has meant the
weakest volumes
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Tobacco 8
Figure 15: Price versus volume for tobacco: elasticity is in
line with historical rates (0.3-0.5)
Figure 16: Notable deterioration in EEMA and EU regions
1999
20002001
2002
2003
200420052006
20072008
2009
2010
2011
2012
R = 0.8444
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
0% 2% 4% 6% 8% 10%
Vo
lum
e g
row
th
Price/mix (constant currency)
Elasticity 0.3-0.5
EU
EEMA
AsiaPac*
Americas*
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
3%
-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5%
Vo
lum
e gr
ow
th 2
008-
2012
(C
AG
R)
Volume growth 1998-2008 (CAGR)
Deteriorated
Improved
Source: Euromonitor (Cigarettes + OTP) Source: Company data, Euromonitor. *Excludes China and USA
That is not to say all markets are in decline big markets such as Indonesia and India
have grown in the low-to-mid single digits over the past five years. However, increasing
health concerns together with the ever-tightening government clampdowns (be it taxes,
packaging and labelling restrictions, smoking bans in public places, health warnings or
consumer education) have set the overall industry in long-term structural decline. The
trend in each case is well set as authorities continue to tighten legislation/tax.
Figure 16 showed the change in growth rate by broad region, but the same message can
be found by looking at the top 30 countries (by market size/volume) again showing the
generally deteriorating growth rates of the past five years (2008-13) versus that seen in
the five years previously (2003-08).
Some markets are still
growing despite the
health/economic pressures
Most markets have slowed
in the past 4-5 years
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Tobacco 9
Figure 17: Top 30 volume markets (ex China/USA) South and Eastern Europe volumes deteriorated in 2008-13
Russia
Indonesia
Japan
IndiaPhilippines
Brazil
Turkey
South Korea
Ukraine
Germany
Egypt
Italy
Vietnam
Pakistan
Spain
Poland
France
Argentina
UK
Thailand
Taiwan
Mexico
Canada
UAE
Romania
S Africa
Saudi Arabia
Kazakhstan
Algeria
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
8%
-10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%
Vo
lum
e g
row
th (
CA
GR
2008-1
3)
Volume growth (CAGR 2003-08)
Improved relative
to 2003-08 trend
Deteriorated relative
to 2003-08 trend
Source: TMA, 2008-12 where 2013 data is not available yet (e.g. Vietnam, Pakistan, Thailand, Taiwan, UAE, Romania, S Africa, Saudi Arabia)
We suggest there are five macro factors at work here:
1: Increased levels of unemployment
Below we show the change in unemployment in these two key regions (EU and EEMA),
comparing the rate in 2012 with that in 2008 (there has been an increase in unemployment
in virtually every market).
Similarly, the market growth rates have deteriorated (comparing the growth rate pre 2008
with that seen post 2008).
Put simply, unemployment has gone up and the market growth rates have slowed (most
countries lie in the bottom right-hand quadrant of Figure 18 and Figure 19).
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Tobacco 10
Figure 18: Deterioration in EU cigarette volume growth
(2008-2012 v 1998-2008) versus change in unemployment
(2012 v 2008)
Figure 19: Deterioration in EEMA volume growth (2008-
2012 v 1998-2008) versus change in unemployment (2012
v 2008)
Austria
Belgium
Denmark
Estonia
Finland
FranceGermany
Greece
IrelandItaly
Latvia
Lithuania
NetherlandsNorway
Poland
Portugal
Spain
Sweden
Switzerland
United Kingdom
-16%
-12%
-8%
-4%
0%
4%
-3% 0% 3% 6% 9% 12% 15% 18%
Ch
an
ge in
vo
lum
e g
row
th (
'98
-'0
8 v
s '0
8-'
12
)
Change in unemployment rate (from 2008 to 2012)
Russia
Turkey
Ukraine
Egypt
Iran
Romania
Kazakhstan
Algeria
Saudi
ArabiaSouth
Africa
Czech
Nigeria
Morocco
Serbia
Azerbaijan
Tunisia
Hungary
Bulgaria
Israel
Slovakia
Croatia
Georgia Slovenia
Lithuania
Estonia
Latvia
Bosnia
Macedonia
-25%
-20%
-15%
-10%
-5%
0%
5%
-3% 2% 7% 12%
Change in v
olu
me g
row
th (
'98-'
08 v
s '08-
'12)
Change in unemployment rate (from 2008 to
2012)
Source: Euromonitor, IMF Source: Euromonitor, IMF
2: Decline in disposable incomes
The decline in real disposable incomes in Europe has been a reasonable indicator for
overall cigarette volume growth/declines in Europe (Figure 20).
Figure 20: EU Pressure on disposable incomes has hit cigarette volumes
-3%
-2%
-1%
0%
1%
2%
3%
4%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
Q1 0
0
Q4 0
0
Q3 0
1
Q2 0
2
Q1 0
3
Q4 0
3
Q3 0
4
Q2 0
5
Q1 0
6
Q4 0
6
Q3 0
7
Q2 0
8
Q1 0
9
Q4 0
9
Q3 1
0
Q2 1
1
Q1 1
2
Q4 1
2
Q3 1
3
EU indsutry volumes (12m rolling) EU real disposable incomes (RHS)
Source: EU market volumes as indicated by PMI, Disposable incomes as estimated by Oxford Economics
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Tobacco 11
3: Excise duties have risen at a faster rate in the past four years
Whether it is a new-found zeal on health concerns, or tighter fiscal budgets and the need
to find more income, or indeed a combination of these either way European countries
have all been increasing their levies on the tobacco industry at a higher rate over the past
four years than previously. The European Union gives numbers that support this notion,
notably over the past three years.
Figure 21: Selling prices and excise per 1000 sticks in the
EU
Figure 22: % increase in excise duty across the EU for
tobacco products
0
50
100
150
200
250
300
20
00
20
01
20
02
20
03
20
04
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05
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06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
Prices (EUR per '000 stick) Excise
EU expansion
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
2006 2007 2008 2009 2010 2011 2012 2013
Source: Credit Suisse research based on EU releases Source: Credit Suisse research based on EU releases
The same can be said for the EEMA region although we do not have uniform data from
the EU, we can see that the percentage of the selling price accounted for by excise duty
has risen significantly in the major markets across the region over the past four years
(Figure 23).
Figure 23: Excise duty as a % of the selling price for major markets in the EEMEA region
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
2008
2012
Source: Credit Suisse research based on Euromonitor data
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Tobacco 12
Fine-cut, or roll-your-own (RYO), has historically offered some growth, although this has
also slowed sharply. RYO has historically enjoyed preferential excise tax treatment in most
European countries, although this is beginning to be eroded.
In 2012, lost excise tax on cigarettes outweighed the increase in tax revenues collected
from growth in fine-cut products in a number of big European markets, notably Italy and
Spain where authorities increased excise on fine-cut tobacco in Q4 '12 and Q2 '13,
respectively.
Figure 24: Pressure on tax revenues as fine-cut no longer
offsets declining cigarette excise
Figure 25: Growth in fine-cut (RYO) slowing as tax gaps
close (e.g. Spain, Italy)
-600
-400
-200
0
200
400
600
800
1,000
2009 2010 2011 2012
Change in tobacco excise revenues (m euro)
Spain Italy Germany
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
EU RYO vol growth
Significant excise increases on fine cut tobacco (e.g.
Italy, Spain)
Source: The European Commission, Credit Suisse research Source: Euromonitor, Company data
Fine-cut tobacco volumes in Europe have been roughly flat since the excise increases,
which have put prices more in line with cigarettes in these markets (Figure 25).
4: Illicit trade has increased significantly
The illicit trade has been a persistent thorn in the side for both the tobacco industry and
governments. It accounts for ~10% of cigarette volumes in the past decade but has
increased sharply over the past four years coinciding with the weaker industry volumes.
Arguably, the factors highlighted above have themselves all contributed to this increase.
The drivers behind the illicit trade are in general;
Tax differentials between countries, which make it attractive to move volumes from
low-excise countries across borders.
What represents the interest of one country might not represent the interest of
another collecting excise taxes and stemming the illicit trade in Country A versus
profits and employment in Country B.
There are frequently strong local, often political, interests in the ownership of the illegal
exporters.
Excise duty represents a large proportion of the selling price of tobacco, rendering a
significant opportunity to the illegal trade that avoids such duty. The fines are small
compared with the profits that can be achieved.
Price increases are a fundamental part of the tobacco industry structure there is
persistent pressure on pricing, particularly at times of lower disposable incomes and
higher unemployment.
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Tobacco 13
Not all sources agree on the extent of contraband/illicit trade, which is hard to measure.
Euromonitor puts the figure at 12% globally, while KPMG, in a specially commissioned
report, puts the figure at 11% in the EU.
Figure 26: Global illicit trade as a % of market (ex China
and US) volume
Figure 27: Contraband and counterfeit share of EU
market volume
0%
2%
4%
6%
8%
10%
12%
14%
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
2006 2007 2008 2009 2010 2011 2012
Source: Euromonitor to 2012, Credit Suisse estimate 2013 Source: KPMG
Not surprisingly, the penetration of illegal products into the total tobacco market has a
strong economic sensitivity with the illegal trade increasing when the consumer is under
increased pressure. We illustrate the point by comparing the percentage of illicit trade with
unemployment rates (1yr lag) in countries with high unemployment (Figure 28).
Figure 28: Illicit penetration sensitive to changes in unemployment (for countries with
unemployment rates above 8%)
6%
7%
8%
9%
10%
11%
12%
13%
14%
2006 2007 2008 2009 2010 2011 2012 2013
Illicit % total consumption Unemployment rate (1 year lag)
R^2 = 0.89
Source: Euromonitor, KPMG, IMF Note : No 2013 data available yet
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Tobacco 14
The regions where illicit trade has stepped up are EEMA (in particular) and western
Europe consistent with some of the market data illustrated above (Figure 16) showing
that volumes have been weakest in these regions.
Figure 29: Illicit increase across regions Figure 30: Acceleration mainly driven by MEA and W EU
6.0%
3.0% 2.8%
1.9%
1.1%
0%
1%
2%
3%
4%
5%
6%
7%
MEA W Europe Asia Americas E Europe
Increase in illicit penetration (2007-12)
4%
6%
8%
10%
12%
14%
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
Global illicit penetration
W Europe
MEA
Source: Euromonitor Source: Euromonitor
5: The rise of e-cigarettes
e-cigarettes may have only taken a modest share of the total tobacco market, but their
coverage in the media has been high. The press has regularly reported on the size,
growth, implications, penetration and potential of this market. We discuss this in more
detail in the following section.
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24 March 2014
Tobacco 15
New technology In contrast to the market issues explored previously, the threat (or opportunity) from new
technologies can be considered more structural in nature. Reduced-risk products are still
only a modest part of total tobacco consumption. e-cigarettes today account for roughly
0.3% of global volumes, with 1-2% penetration rates in a couple of markets (Figure 32),
but growth has been exponential.
The category has attracted considerable attention over the past two years as e-cigarettes
receive extensive publicity and impressive distribution in a number of developed markets.
The US is probably the best test-case region given its early adoption of e-cigarettes and
the detailed market data available here to help track the industry (Figure 31).
Figure 31: US sales: e-cigarettes established as the preferred tobacco "alternative"
0
200
400
600
800
1000
1200
1400
2007 2008 2009 2010 2011 2012 2013e
US
Sale
s (
$m
)
Snus e-cigarettes
Source: Snus based on Reynolds and Swedish Match, e-cigarettes based on PMI presentation (Nov 2013)
We will look more closely at the US later, but first provide some background information:
The potential for new technologies should be reviewed on the basis of four key factors:
Availability: thus far e-cigarettes have mainly been launched in Europe and North
America.
Regulation: There is currently no consensus on how to regulate reduced-risk
products with country and government/health lobby attitudes ranging from highly
favourable to advocating an outright ban on e-cigarettes. or regulating them as a
medicine.
Tax: thus far there is no consensus on how to categorise them. Should they be taxed?
At what rate? If they are to make a meaningful dent in tobacco sales, a considerable
loss of revenue to the various exchequers would ensue.
Technology: formulation challenges remain; the e-cigarette experience does not fully
mimic that of smoking a cigarette in the eyes of the consumer and hence full adoption
has remained low.
e-cigarettes a lot of media
attention, but still very small
in global terms
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24 March 2014
Tobacco 16
Availability
e-cigarettes have been launched mainly in Europe and the US. Penetration rates remain
low (under 2% of the tobacco and related products market), with global retail sales around
$2-3bn compared with c$780bn for the total tobacco category.
The increasing involvement of the global tobacco manufacturers might change the
landscape, but thus far launches have been in relatively wealthy countries with high
tobacco taxes.
Figure 32: e-cigarette as a % of total market remains small thus far (2013 data)
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
USA W Europe Global
e-cigarettes % of volumes
Source: BAT survey (CMD 2013)
Currently, margins on e-cigarettes for retailers are large (and small on tobacco). Little
surprise then that the new technology is afforded significant shelf space, over and above
its share of sales.
Technology
Surveys of smokers show high awareness and trial of e-cigarettes; however, thus far trial
rarely leads to regular, or exclusive, use of e-cigarettes (Figure 33).
Figure 33: Low conversion to exclusive use of e-cigarettes
94%
23%
5%N/A
100%
41%
11%
N/A
75%
35%
10%2%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Awareness Trial Regular use Exclusive use
CDC survey (USA) Oct '11 CDC May '13 BAT survey (EU & USA) Sep '13
Source: US Centers for Disease Control and Prevention, Company data
Thus far only really seen in
developed markets
-
24 March 2014
Tobacco 17
Lorillard (the US market leader in e-cigarettes) claimed at its recent Capital Markets Day
that awareness was now close to 100%, 43% had trialled the product and that there was
26% repeat usage based on survey data.
The low conversion suggests that the consumer does not think e-cigarettes are a
substitute for the feel and flavour of cigarettes. Reasons for the slow or low uptake
of e-cigarettes voiced by users include:
The technology does not match the nicotine delivery profile. A traditional cigarette
delivers a fast and high concentration of nicotine to the bloodstream. This contrasts
with e-cigarettes where the uptake is slower and not as impactful (Figure 34).
Figure 34: Cigarettes still the better option for nicotine delivery
0
2
4
6
8
10
12
14
16
18
20
0 5 10 15 20 25 30 35 40 45 50
Nic
otine b
lood c
oncentr
ation
Time (minutes)
Cigarettes e-cigarettes
Source: Data from PMI Capital Market Day (2012)
The new technology lacks the 'bite' of a traditional cigarette. The burning or kick
sensation from inhaling smoke is absent in an e-cigarette.
Taste is still an issue with many consumers
and it would appear that the satisfaction and finite nature of a single cigarette is not
matched.
So while consumers are showing a willingness to try an alternative nicotine delivery
mechanism, the current technology is still found to be lacking. Not all e-cigarette users are
those who are looking to give up smoking and some are using the new technology in place
of other more traditional quitting methods gums, patches, prescription drugs, hypnosis, etc.
AC Nielsen research for the UK from 2013 showed 47% of those who tried e-cigarettes did
so as a part of their NRT (nicotine replacement therapy), but that 53% were trying the
product in its own right.
The reasons given for trying e-cigarettes again we draw on AC Nielsen's study in
the UK are all related to reductions in tobacco intake or as a substitute to traditional
forms of nicotine intake.
Smokers seem willing to try,
but the experience appears
to fall short
e-cigarettes used mainly by
those trying to quit? No
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24 March 2014
Tobacco 18
Figure 35: What are the benefits of e-cigarettes (UK sample)
0% 20% 40% 60% 80% 100%
Point of entry
Complement existing habit
Price
Convenience
Instead of patches
Harm reduction
Route to reduce intake
Doesn't make me smelll
Alternative to smoking
Source: AC Nielsen study in the UK (2013)
We note that price was not one of the main factors highlighted in Nielsen's survey, despite
the price differential between e-cigarettes and normal cigarettes a topic that might be
tested if taxes start to be imposed on this burgeoning category.
What comes after e-cigarettes?
New technologies are being developed by the major tobacco manufacturers. PMI and BAT
are making steady progress on different technology platforms, including heat-not-burn.
Initial consumer trials of PMI's heat-not-burn product have indicated a more favourable
consumer experience and willingness to adopt the product (Figure 36). Perhaps the closer
proximity to a traditional cigarette widens the appeal of reduced-risk products.
US start-up Ploom has already introduced a product that heats small pods of real tobacco.
The product was introduced in the US in 2012 and was launched in Austria (May 2013)
and Japan (Dec 2013) through Ploom's partnership with Japan Tobacco.
PMI and BAT aim to launch heat-not-burn products within the next few years. PMI
estimates that the market could be 30-50bn units, with profitability in line with cigarettes
(Figure 37). An assertion that would be highly sensitive to the eventual regulation and
taxation of reduced-risk products, in our view, for which there is currently no consensus.
Figure 36: Promising consumer tests Survey data from CDC and initial PMI test results
Figure 37: PMI expects profits in line with cigarettes Profit per '000 unit (USD)
0%
10%
20%
30%
40%
50%
60%
70%
80%
Japan sample Italy sample US market
PMI's platform 1 (heat-not-burn) E-cigarettes
Purchase intention Adoption
0
5
10
15
20
25
30
PMI cigarettes PMI EU region Platform 1
Profit per '000 unit (USD)
Source: CDC, PMI (CAGNY '14) Source: Company data, Management estimates (CAGNY 2014)
-
24 March 2014
Tobacco 19
Regulation
Right at the heart of regulating reduced-risk products is a major conflict; indeed it is a
clash that exists throughout the industry. Health versus taxes. While encouraging the
uptake of the apparently more healthy (or less unhealthy?) e-cigarette may be positive for
the health of the nation, it does, as things currently stand, mean a considerable drop in the
excise takings of a country if consumers switch. Should e-cigarettes be subject to excise
duty or not?
Should the numerous restrictions on cigarette advertising, smoking in public places,
retailing etc. apply to e-cigarettes as well? What is clear is that there is no consensus right
now. The debate continues in the media, and countries are all taking very different lines.
Here are a list of examples, by no means exhaustive, but illustrative of the different
direction many are taking:
Indonesia, Argentina, Brazil (with a large tobacco industry), Turkey, Singapore: ban on
e-cigarette sales
South Korea: internet sales banned
Australia: online purchase (imports) for personal consumption allowed
World Health Organisation: Advise strongly against use of e-cigarettes
Canada: health authorities issued warnings against use of e-cigarettes
Malaysia: requires a prescription and only sold through pharmacies
Romania: considered as medicinal product
Italy: has implemented excise taxes on e-cigarettes
The EU: has proposed legislation to allow member states to determine most aspects
of regulation with some restrictions on nicotine content and product standards
The US: few restrictions, but with variations by state. e-cigarettes are included under
existing smoking bans in over 100 cities (e.g. New York, Boston and Seattle)
Tax
Just as there is no accord on regulating e-cigarette usage, so there is no consensus on tax.
If the new technology is to have a meaningful impact on the sales of cigarettes there will
be an ensuing loss of excise duty to the various exchequers. This needs to be weighed
against the health implications should regulators not encourage consumers towards the
healthier option?
We think that a tax will be applied to e-cigarettes, albeit at what rate and what structure
remain to be seen.
Thus far the only two major countries to have implemented taxes on e-cigarettes are:
Italy the same level of tax as roll-your-own
Latvia the same tax as standard cigarettes
In the US, Minnesota is thus far the only state to have implemented a tax on e-cigarettes
(at 95% of the wholesale price), although others are considering it. We think 2014 is likely
to see significant developments on this front.
To ban/restrict or not to
ban/restrict?
Tax structure yet to evolve
on the new technology
-
24 March 2014
Tobacco 20
US market the test market for e-cigarettes?
The US market is certainly the most advanced when it comes to the e-cigarette category.
From a base of under $10m in 2007, sales are estimated to have reached over $1bn in
2013, almost double that recorded in 2012 (Figure 31).
Sales are increasing at a rapid rate and the established tobacco manufacturers (Altria,
Reynolds and Lorillard) have all launched their own versions of the product.
Lorillard acquired e-cigarette maker blu at the beginning of 2012 and has quickly
established itself as the market leader (Figure 38).
Figure 38: Lorillard's blu brand now ~50% share in retail Figure 39: Growth has moderated in the past few
quarters, despite distribution expansion
0%
10%
20%
30%
40%
50%
60%
$0
$10
$20
$30
$40
$50
$60
$70
Q2 12Q3 12Q4 12Q1 13Q2 13Q3 13Q4 13
LO e-cigarette net sales (m USD) Mkt share
$0
$100
$200
$300
$400
$500
$600
Q2 12 Q3 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13
Retail sales ($m 12m trailing, implied from LO mkt share)
Source: Company data, management estimates of retail market share Source: Company data
Taking Lorillard's reported e-cigarette sales and its management's estimates of its own
market shares over the past 12 months would imply market growth has been moderating
in the past couple of quarters (Figure 39). Lorillard claimed at Q4 that increased
distribution in previous quarters had exaggerated growth rates and that volumes were flat
in Q4 (with prices coming down).
Numbers from AC Nielsen (measuring retail sales in four-week periods) show sales
peaking midway through 2013, and declining month-on-month since then (and unit sales
remaining broadly flat). Notable too are the big jumps in January every year as consumers
try to break the smoking habit.
Numbers from Reynolds Capital Markets Day also suggest that e-cigarette's share of the
cigarette market is moderating (Figure 41) perhaps an indication of low repeat
purchases as some surveys have suggested.
New technology threat?
Recent data point to a
market past its peak have
e-cigarettes burnt out?
-
24 March 2014
Tobacco 21
Figure 40: Monthly e-cig sales level off in US retail Figure 41: and penetration stabilises
0
1
1
2
2
3
3
0
2
4
6
8
10
12
14
16
Sep 1
1
Oct
11
Dec
11
Feb 1
2
Apr
12
Jun 1
2
Aug 1
2
Sep 1
2
Nov
12
Jan 1
3
Mar
13
May
13
Jul 1
3
Aug 1
3
Oct
13
Dec
13
Feb 1
4
Retail sales (m USD) Volume (m units, RHS)
0.0%
0.1%
0.2%
0.3%
0.4%
0.5%
0.6%
0.7%
0.8%
0.9%
1.0%
Oct
-12
Nov-
12
Dec-
12
Jan-1
3
Feb-1
3
Mar
-13
Apr-
13
May
-13
Jun-1
3
Jul-13
Aug-1
3
Sep-1
3
Oct
-13
Equivalent share of total cigarettes
Source: AC Nielsen Source: MSAi shipments to retail (from RAI CMD 2013)
Will tobacco companies win this market?
It might be argued that the tobacco companies are best placed to win in the e-cigarette
marketplace given their distribution strengths, marketing expertise and scale. Bulls might
highlight that the leaders in the US e-cigarette are the leading tobacco companies which
is true, but the share of e-cigarettes is not the same as their share of tobacco currently.
Figure 42: US market shares of e-cigarettes and cigarettes (%)
Market share of cigarettes Market share of e-cigarettes
Lorillard 10 46
Altria 57 0
Reynolds 27 0
Fin Brand 20
NJoy 11
Others 6 13
Total 100 100
Source: AC Nielsen, 12m trailing based on February 2014 release
This is a matter of timing, and phase of development: Altria and Reynolds only very
recently entered the market; so their success will need to be monitored. Does being a
large tobacco company offer a big advantage? It would appear so:
Lorillard: has taken blu's market share from 11% when it was acquired (April 2012) to
46% today.
Reynolds launched VUSE in Colorado in July 2013, and by October it claimed to
account for 61.6% of the e-cigarette market in the state.
Figure 43: Tobacco companies' entry into e-cigarettes
Date Venture
Imperial Tobacco 2013 Bought Dragonite Intl for $75m
BAT 2012 Bought a UK start up in 2012, launched Vype in the UK in 2013
PMI 2014 Building a $500m plant in Italy and expects to enter the market in 2014/15
Lorillard 2012 Acquired blu in the US for $135m, now the market leader
Reynolds 2013 Launched VUSE in Colorado in 2013
Altria 2013 Launched Mark Ten in two states. Bought Green Smoke in 2014 for $110m
Source: Company releases
New technology
opportunity?
Being a major tobacco
incumbent appears to be a
significant advantage in the
e-cigarette market
-
24 March 2014
Tobacco 22
Profitability
Another important consideration is the profitability of this new technology. If it is to make
significant inroads into the traditional tobacco trade, what are the implications for profits?
To simply look at the margins is misleading in our view and we think it is better to look at
the implied profit per pack of cigarettes or cigarette equivalents.
Figure 44: Profit per pack of cigarettes (or equivalent) for leading names ($/pack of 20)
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
Lorillard Altria Reynolds LO Blu Vapor
Corp
PMI Imperial BAT
Source: Credit Suisse estimates based on latest available company releases
The Lorillard numbers reported for blu, or indeed the results of the public company Vapor
Corp (both US), imply profits lower than the tobacco companies in the US, but higher than
their European counterparts on an equivalent basis.
It is perhaps a little early to draw definitive conclusions as such a nascent technology has
yet to settle down in price and the tax structures have yet to be put in place. With barriers
to entry so low, we would expect price erosion and/or competition to lower the current
returns.
Summary
e-cigarettes remain a small part of the global tobacco market owing partly to
availability, regulation and limitations of the current technology.
Interest is high and a large number (over a third) of smokers seem willing to try the
new technology
however, thus far e-cigarettes have not been able to match the experience of a
cigarette for the consumer.
Other technologies are emerging; more promising products are being developed by
established cigarette manufacturers. The UK market leader commented that the group
is on its 10th-generation product today versus three years ago (e-lites). Technology is
improving at a rapid pace.
If the technology can match the experience of the 'real thing', then reduced-risk
products could go a long way.
-
24 March 2014
Tobacco 23
There is no consensus on regulation yet: a number of markets have banned e-
cigarettes (e.g. Indonesia, Thailand, Argentina, Brazil, Mexico, Lithuania, Egypt, GCC,
Iran and Norway).
Current regulation gives e-cigarettes an advantage in a number of markets, but
regulation is emerging and further penetration is likely to result in more restrictions on
marketing, points of sale, age limits, etc. Note that the UK has just banned sales to
under 18s.
Nor has there been any accord on excise duty
e-cigarettes have experienced rapid growth in the US over the past two years, with a
proliferation of brands available in the market. However, launches by tobacco
manufacturers such as Lorillard and Reynolds have achieved market leadership in the
segment after a relatively short period in the market. Current incumbents have a
significant advantage based on the US experience.
There are signs that growth of e-cigarette sales has moderated and share of the
cigarette market (on an equivalent basis) is stabilising in the US, even declining. A
pause for breath, or an indication of a technology shortfall?
e-cigarettes may be an opportunity for revenue, but we see them as a threat to
industry profitability.
A final thought traditional terminal growth for a tobacco company in a DCF might be
zero or even negative. Do e-cigarettes give tobacco valuation a terminal growth?
We believe the greater threat, however, is to the brand equities of the tobacco companies.
While they may well embrace the new technology and build their own e-cigarette brands,
the barriers to entry are low. The tobacco companies have a built-in advantage with
distribution, but what value then to ascribe to Marlboro (ranked the 8th most valuable brand
in the world by CNN and Millward Brown*)? The brand value destruction wrought by e-
cigarettes (if the new technology gets to the required level) could be significant. Years of
brand building could count for little. There is no other consumer staple where this risk
exists.
(*) Interestingly Interbrand no longer recognises Marlboro as being in the top 100 after
being ranked 9th 10 years ago
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24 March 2014
Tobacco 24
Prospects where to from here? The higher volume declines over the past five years are, in our view, due to:
(1) Increased levels of unemployment
Reductions in disposable incomes
Increased levels of excise duty/price hikes
All leading to, and further exacerbated by increased levels of illicit trade
Growth in e-cigarettes and new technology (given e-cigarettes are still under 0.5% of
the market their impact has perhaps been rather less than the column inches
dedicated to them in the world media)
Economic indicators improve?
On the first two trends there are macro forecasts that might offer some encouragement;
both unemployment levels (Figure 45) and disposable incomes (Figure 46) are forecast by
most economists to improve over the next few years (at least in the EU, which has been
one of the weakest regions).
Figure 45: EU unemployment expected to stabilise in
2014
Figure 46: and disposable incomes improve
7%
8%
9%
10%
11%
12%
13%
Oxford Econ IIF IMF
-3%
-2%
-2%
-1%
-1%
0%
1%
1%
2%
2%
3%
3%
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
Q2
07
Q4
07
Q2
08
Q4
08
Q2
09
Q4
09
Q2
10
Q4
10
Q2
11
Q4
11
Q2
12
Q4
12
Q2
13
Q4
13
EU volumes EU real disposable incomes (RHS)
Source: IMF, IIF, Oxford Economics Source: Oxford Economics
Excise duty pressures
On excise duty the position is less clear. A few countries have a long-term explicit agenda
clearly laid out: e.g:
UK 2% price increases over UK inflation
Brazil 8% and 5% pass-on pricing over the next two years
Russia tax increases, which will push retail prices up by 15-20% p.a. over next three
years
Australia 12.5% per annum tax increase over the next three years
Philippines 15-20% and 3-6% price increases p.a. on economy and premium
brands, respectively, over the next five years.
-
24 March 2014
Tobacco 25
However, these are the minority. In general excise duty varies widely by country. If we
compare the average price in the 50 biggest markets (by volume) and see the tax
component in the selling price, the range varies from a $10 tax per pack (20 sticks) in the
UK and Australia to 10 in some countries. These numbers should be interpreted with
some care, as there is also a difference in quality from country to country.
Figure 47: Average price per pack (20) in countries split between tax and "other"
0
2
4
6
8
10
12
14
Aus
tral
ia
UK
Can
ada
Net
herla
nds
Fra
nce
Ger
man
y
Bel
gium
USA
Italy
Aus
tria
Japa
n
Spa
in
Gre
ece
Cze
ch
Chi
le
Rom
ania
Sou
th A
fric
a
Ven
ezue
la
Pol
and
Mal
aysi
a
Tur
key
Hun
gary
Mor
occo
Tai
wan
Kor
ea
Bra
zil
Sau
di A
rabi
a
Iran
Aze
rbai
jan
Mex
ico
Tha
iland
Arg
entin
a
Alg
eria
Indi
a
Ser
bia
Chi
na
Rus
sia
Col
ombi
a
Ukr
aine
Egy
pt
Vie
tnam
Tun
isia
Indo
nesi
a
Nig
eria
Kaz
akhs
tan
Phi
lippi
nes
Tax component (USD per pack) Net sales
Source: Credit Suisse research based on TMA data
The concern here is the sheer volume of excise duty that some countries are missing out
on. Consumers' ability to pay from one country to the next will vary greatly, so a more
meaningful picture might be drawn by comparing the price of a cigarette to disposable
income or as a percentage of the average hourly wage, as we highlight in Figure 48.
Figure 48: Packet of cigarettes expressed as a % of the average hourly wage
0%
10%
20%
30%
40%
50%
60%
2000
2008
2012
Source: OECD database, TMA
A quick scan of some of the largest markets shows that the real cost of a packet of
cigarettes has risen, and continues to do so in every market.
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24 March 2014
Tobacco 26
In part this reflects the economic backdrop where average wage inflation has slowed (or
gone into reverse given the unemployment backdrop). However, it is striking that if we
compare the increase in the cost of a packet of cigarettes as a percentage of the hourly
wage (2008-12 versus 2000-08) versus the change in volume growth, all the countries with
high price pressure lie in the bottom right-hand quadrant (i.e. the pace of cigarette inflation
has accelerated, as has the rate of decline in consumption).
Figure 49: Increase in rate of tobacco inflation (as % hourly wage) has led to an increase rate of decline in consumption
AustraliaUK
Canada
Netherlands
France Germany
Belgium
USAItaly
Austria
Japan
SpainGreece
Czech
Poland
HungaryKorea
-20%
-15%
-10%
-5%
0%
5%
10%
-2% -1% 0% 1% 2% 3% 4% 5% 6%
Change in v
olu
me g
row
th r
ate
(00-0
8 v
s 0
8-
12)
Change in rate of price pressure (pack % hourly wage) 2000-08 vs 2008-12
Source: TMA, OECD database
Excise duty increases on tobacco have consistently been above other indulgences (Figure
50), leading to large increases in relative pricing.
Figure 50: UK retail price indices for beer, tobacco, wines/spirits, etc
0
50
100
150
200
250
300
350
400
450
500
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Soft drinks confectionery beer
tobacco Wine & Spirits RPI
Source: ONS
We do not have the data for all countries but the UK is illustrative over the past 20 years
tobacco prices are up over 350% versus under 100% for the RPI, with not dissimilar
numbers for beer, wines and spirits.
Has tobacco reached an
inflection point in the
historical pricing model?
-
24 March 2014
Tobacco 27
Illicit trade a structural issue
There are continuing actions to limit the illicit trade, which include:
Funding and intelligence gathering for government agencies (e.g. European Anti-
Fraud Office, Interpol, and Customs agencies).
Legislation to create deterrents and improve enforcement.
Regulate sale of essential materials used in cigarette manufacturing (e.g. chemicals,
machinery, paper, etc.).
Pressure on known supplier countries to lower production quotas (e.g. Belarus).
Implementing measures to stem the illicit trade at its source is likely to remain a major
challenge for the industry, but progress is being made significant revenues can be lost if
this is allowed to persist. However, as we highlighted earlier the following factors make the
illicit trade attractive to some:
Low penalties
Conflicts of interest between exporting and importing countries
Political interests
Large tax discrepancies that continually increase
It is hard for us to see how a meaningful reduction will be seen in the illicit trade.
We also note that four years of a high level of illicit trading has left the consumer familiar
with the concept of buying cheap illegal cigarettes. We think it is less of a concern to the
public than it might have been.
Credit Suisse outlook
Overall our outlook for the next 3-5 years are that:
The macro drivers for the industry should improve somewhat and volumes are likely to
recover but not to previous levels. We see continued pressures on smoking and no
let-up from the health and government lobbies. We assume volumes will continue to
decline.
The Illicit trade will remain a problem in our opinion the price gaps are simply too
large and consumers have learnt to buy illicit tobacco. Supply routes are well
established and prevailing conflicts between countries are too numerous for this to
materially close.
New technology and e-cigarettes are likely to remain an important but modest new
avenue for the industry. A material change in technology could change this.
Declining industries have a habit of consolidating and tobacco has a strong history in
this regard. Assets are declining and we believe we are getting closer to the possibility
that there may be some consolidation among the majors.
No material reverse in
quantum of illicit trade
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24 March 2014
Tobacco 28
Industry consolidation Much like its brewing counterpart, the global tobacco industry has been consolidating for a
number of years. Over the past decade the market share (world ex US and China) of the
top four names has gone from about 60% to almost 80%.
Figure 51: Top 4 tobacco companies comprise almost 80% of the international market
50%
55%
60%
65%
70%
75%
80%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Top 4 tobacco % international market (ex China, USA)
JT: Gallaher
IMT: Altadis
BAT: STG, Tekel
PMI: Fortune
Source: Euromonitor
With large synergies gained, and modest multiples paid, we think this process has helped
fuel the outperformance in earnings growth seen in tobacco (versus other staples).
However, future opportunities for further consolidation are beginning to look rather
limited in Europe and Latin America markets are dominated by the Big 4 (PMI, BAT,
Imperial Tobacco and Japan Tobacco). A few isolated possibilities remain in EEMA and
Asia (Figure 52) these are either state-owned assets, or predominately domestic
operations, e.g. in Indonesia, Korea, Vietnam, Egypt, Iran, Bangladesh and Thailand.
Figure 52: Still some options in Asia and EEMA
4%
18%
42%
10%
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
EU EEMA Asia (ex China) Americas (ex USA)
Market share not held by Big 4 tobacco
Source: Company data
Consolidation has been a
key plank of industry
development
but there are fewer
opportunities around now
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24 March 2014
Tobacco 29
Figure 53: Global Tobacco landscape market shares of the Big 4 tobacco companies
Volumes (bn) Growth '07-12 PMI BATS JT IMT Other Other Companies
Europe 520 -5% 38% 20% 17% 21% 4%
Germany 83 -1% 36% 19% 4% 26% 15% Private label
Italy 79 -3% 53% 23% 21% 3% 0%
Spain 57 -10% 31% 12% 20% 28% 9%
Poland 52 -6% 36% 29% 10% 23% 2%
France 52 -1% 40% 16% 17% 23% 5%
UK 43 -3% 7% 7% 39% 45% 1%
Greece 23 -9% 37% 19% 13% 12% 20% Karelia, STG
Czech 21 -2% 42% 20% 7% 14% 17%
Austria 14 1% 35% 6% 33% 19% 6%
Netherlands 12 -3% 32% 27% 16% 11% 14%
Hungary 12 -6% 38% 37% 5% 13% 8%
Belgium 11 -1% 30% 32% 11% 16% 11%
EEMA 1235 -1% 25% 22% 23% 12% 18%
Russia 370 1% 26% 21% 37% 9% 7% Donskoy, KT&G
Turkey 99 -4% 46% 22% 26% 4% 2% European tobacco
Ukraine 83 -9% 32% 17% 28% 22% 1%
Egypt 78 -2% 17% 8% 0% 0% 75% Eastern Co
Iran 56 0% 0% 14% 32% 0% 55% Iranian Tobacco, KT&G
Belarus 33 12% 0% 16% 22% 2% 60% Neman Tobacco
Romania 31 -1% 19% 50% 23% 0% 8%
Kazakhstan 30 0% 47% 7% 43% 3% 0%
Algeria 30 4% 40% 1% 3% 11% 45% SNTA
Saudi Arabia 26 6% 62% 15% 0% 9% 14%
South Africa 22 -2% 3% 86% 4% 0% 7%
Nigeria 17 1% 2% 80% 10% 7% 1%
Morocco 16 1% 9% 0% 2% 81% 8%
Serbia 15 -9% 51% 19% 7% 0% 23% Adris Grupa, Monus, Karelia
Azerbaijan 14 4% 0% 27% 25% 29% 19% European tobacco
Tunisia 14 -2% 15% 0% 2% 1% 83% RNTA, MTK
Uzbekistan 13 5% 4% 92% 1% 1% 2% KT&G
Bulgaria 9 -15% 13% 13% 0% 0% 74% Bulgartabac, Karelia
Asia 1196 1% 27% 16% 12% 3% 42%
Indonesia 303 5% 36% 8% 0% 0% 56% Gudang, Djarum
Japan 197 -6% 28% 13% 60% 0% 0%
India 102 0% 12% 8% 0% 0% 80% ITC
Philippines 102 2% 85% 1% 6% 0% 8% Mighty
Vietnam 83 4% 2% 31% 1% 10% 56% Vinataba
Korea 89 -1% 19% 12% 7% 0% 62% KT&G
Bangladesh 75 - 0% 44% 0% 0% 56% Dhaka, Abul Khair, Nasir
Pakistan 64 -2% 47% 49% 0% 0% 5%
Thailand 39 3% 22% 2% 0% 0% 76% Thailand Tobacco Mono
Taiwan 36 -4% 0% 8% 39% 12% 42% Taiwan Tobacco & Liquor
Australia 19 -3% 38% 42% 0% 19% 1%
Malaysia 14 -4% 12% 63% 20% 0% 6% AKJ Marketing
Americas 298 -3% 38% 49% 4% 0% 10%
Brazil 87 -5% 17% 64% 0% 0% 19%
Argentina 43 1% 75% 25% 0% 0% 0%
Canada 32 2% 34% 51% 15% 0% 1%
Mexico 34 -6% 74% 26% 1% 0% 0%
Colombia 15 -5% 51% 49% 0% 0% 0%
Chile 14 1% 4% 96% 0% 0% 0%
Venezuela 11 -3% 8% 92% 0% 0% 0%
USA 287 -5% 0% 0% 0% 3% 97% Altria, Reynolds, Lorillard
China 2500 4% 0% 1% 0% 0% 99% CNTC Source: Company data, Euromonitor. Asia excludes China, Americas excludes USA
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24 March 2014
Tobacco 30
Declining cigarette volumes in mature markets and economies of scale across the
production and supply chain have, in our view, made tobacco an industry with scope for
consolidation over time.
Figure 54: M&A multiples average 12.8x on EV/EBITDA (LTM)
0
5
10
15
20
25
30
RJR
Au
stri
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bak
Imas
co
Au
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aban
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e
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emts
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era
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idd
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n
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nce
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ans
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Be
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xico
Min
ori
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Ara
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A
EV/EBITDA multiple (LTM) Weighted average
1999-2000 2004-20062001-2003 2007-2008 2009->
Source: Company data, Thomson Reuters
Takeover multiples in tobacco have been relatively stable averaging roughly 13x
EV/EBITDA (LTM) (Figure 54). The bulk of these transactions have been private assets
taken over by larger public tobacco companies. However, the more notable examples of
consolidation between public companies (e.g. Sampoerna, Altadis and UST) have been
done with bid premiums of roughly 30% to the share price (Figure 55).
Figure 55: Bid premium to share price (at close prior day)
0%
10%
20%
30%
40%
50%
60%
Sampoerna(PMI)
Conwood (RAI) Altadis (IMT) Rothmans (PMI) US ST (Altria)
Bid premium to share price (close) Average
Source: Thomson Reuters
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24 March 2014
Tobacco 31
So what is next? If M&A is to remain a possibility we believe it is a choice between:
Selecting one of the remaining assets identified in Figure 53
Buying minorities in emerging markets (e.g. ITC, Souza Cruz, BAT Malaysia, etc.)
Entering (or re-entering) the US (we assume China will remain closed)
The Top 4 becoming the Top 3
Possible US/China entry?
Throughout this report we have largely ignored the US and Chinese market because of the
limited direct exposure of the international tobacco companies. The two markets account
for almost 40% of global retail sales combined (2013 data), a considerable profit pool for
the industry.
China
The Chinese market is a state monopoly operated by the China National Tobacco
company- CNTC- (in a rare public disclosure net income was reported to be over $18.6bn
in 2010 and delivering over $110bn in annual tax revenues) the largest tobacco
company in the world. The international names all have indirect access to the market
through licence agreements or JVs with CNTC, but remain an insignificant proportion of
the market.
International involvement is likely to remain limited and is at best a long-term option.
Announcements following the Communist Party's Third Plenum (Q4 2013) suggest that
there are no immediate plans to overhaul industries with entrenched state-owned
enterprises (SEOs) and tobacco remains a good fit for a government seeking to extract
higher dividend payments from state-owned companies to help public finance.
US
The US market is dominated by three domestic companies (Altria, Reynolds and Lorillard)
with some degree of indirect exposure from the international tobacco companies.
Figure 56: US market shares in tobacco (2013) Figure 57: US market growth of cigarettes (volume)
Lorillard
9%
Altria
58%
Reynolds
27%
IMT
2%
Vector
2%
Others
2%
-10%
-9%
-8%
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
Source: AC Nielsen Source: TMA
PMI was spun off from Altria in March 2008. There are some agreements between the
two entities such as a strategic agreement to commercialise NGPs (next-generation
products) in the US and abroad. There are agreements also on brands, extensions,
marketing and positioning. Having split the company five years ago, it would be a volte
face to merge, while any other interest in the US is prohibited as a party of the original
de-merger.
China a state monopoly,
unlikely to change any time
soon
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24 March 2014
Tobacco 32
Imperial Tobacco has a small position in the US following the acquisition of
Commonwealth (April '07), but remains a distant number 4 with a ~3.5% market share
(same as in 2007). Imperial lacks the financial capacity to buy its way into the Top 3
(e.g. acquire Lorillard) and management has abandoned the ambition to compete
across the whole market (it now chooses to concentrate its efforts on the 21 states
where it has a more meaningful presence). A merger of equals with Lorillard would
enable Imperial to compete more effectively and give Lorillard distribution in Europe to
launch e-cigarettes. However, this seems unlikely following Lorillard's acquisition of
UK-based e-cig maker SKYCIG (Oct '13
The most speculated upon push into the US will likely remain BAT buying out the
remaining stake in Reynolds (04/03/2014). BAT currently owns a 42% stake in the
company following the merger of B&W's US tobacco business and RJ Reynolds in
2004. The transaction came with a clause limiting BAT's ownership to 42% for 10
years, which is due to expire in July 2014. The structure indemnified BAT from any US
litigation risk at a time when this was a much greater concern for the industry and
investors, but these risks have since subsided.
Press reports (notably the FT 03/03/2014) suggest that Reynolds in the US may bid
for or merge with Lorillard.
Possible Top 4 merger?
The one possible outstanding piece of consolidation is a merger/takeover within the Top 4.
Most permutations would be fraught with anti-trust issues; however, a joint break-up of
Imperial (the smaller of the Top 4) would be feasible and is a possibility that has been
widely discussed in the media and by the industry over the years. We try to illustrate this
using a traffic light system in Figure 58, with red indicating a serious issue, and green
where we believe there are no serious concerns.
Interpreting our table:
A combined share of under 25% is fine (green) that is to say the deal should be able
to go through even if some remedies are required.
If one of the parties in the combination has less than a 5% share then that is fine
(green).
A combined share of 25-40% may constitute a a problem, but may get through, maybe
with some modest disposals (orange).
Everything else is red (serious anti-trust issues that would require a brand disposal).
Mergers among the Big 4
are fraught with anti-trust
issues
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24 March 2014
Tobacco 33
Figure 58: Market share implications by region of a potential Imperial Tobacco takeover
by one of the other three large players
IMT vols IMT share PMI+IMT BAT+IMT JT+IMT
Europe 109 21%
Germany 22 26% 62% 45% 30%
Italy 2 3% 56% 26% 24%
Spain 16 28% 59% 40% 48%
Poland 12 23% 59% 52% 33%
France 12 23% 62% 38% 40%
UK 19 45% 52% 52% 84%
Greece 3 12% 48% 31% 25%
Czech 3 14% 56% 34% 21%
Austria 3 19% 55% 26% 53%
Netherlands 1 11% 43% 38% 27%
Hungary 2 13% 51% 50% 18%
Belgium 2 16% 46% 48% 27%
EEMA 148 12%
Russia 34 9% 36% 30% 46%
Turkey 4 4% 49% 26% 30%
Ukraine 18 22% 54% 39% 50%
Belarus 1 2% 2% 18% 24%
Kazakhstan 1 3% 50% 10% 46%
Algeria 3 11% 51% 12% 14%
Saudi Arabia 2 9% 71% 24% 9%
Nigeria 1 7% 8% 87% 17%
Morocco 13 81% 90% 81% 83%
Azerbaijan 4 27% 27% 55% 50%
Tunisia 0 1% 16% 1% 2%
Uzbekistan 0 1% 5% 93% 2%
Asia 36 3%
Vietnam 9 10% 12% 41% 11%
Taiwan 4 12% 12% 20% 50%
Australia 4 19% 57% 61% 19%
New Zealand 0 20% 26% 92% 20% Source: Credit Suisse estimates based on TMA data (Tobacco Merchants Association)
Although this is a fairly subjective assessment it shows the major problems faced in
several markets and that some divestitures could be forced on any would-be consolidator.
This would throw up the thorny issue of cross-ownership of brands. This is never a
satisfactory state of affairs for any brand owner, but is not unheard of: for example, when
JT bought Gallaher various brands were licensed out in regions of overlaps.
Benson & Hedges: BAT has the brand in most of Asia, and MEA. JT owns the brand in
the EU, Philippines and Thailand; PMI holds the brand in Canada
Peter Stuyvesant, again BAT (Europe, Africa, New Zealand), Imperial Tobacco
(Australia, Germany), PMI (Canada)
Furthermore some brands are licensed by their owners to other producers:
Imperial: Davidoff is licensed to KT&G in Korea (strategic alliance)
Imperial: Gauloises and Gitanes are licensed to BATS in Switzerland and
Liechtenstein
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24 March 2014
Tobacco 34
Imperial: Gauloises and other brands are licensed to BATS in the Netherlands
Imperial: Gitanes licensed to BATS in Argentina
Imperial: Davidoff and West are licensed to PMI in Mexico
BATS, PMI and JT: Brands licensed to CNTC in China and CNTC brands licensed to
internationals
BATS: License all brands to state monopoly in Algeria, Iran and Egypt
PMI: Marlboro was licensed to JT in Japan (1972), but bought back (in 2005)
PMI: License manufacturing of Marlboro to Imperial in Morocco
PMI: License all brands to state monopoly in Egypt and Algeria
Thus, while anti-trust problems exist, and are significant, they are not insurmountable, in
our view.
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24 March 2014
Tobacco 35
Companies Mentioned (Price as of 20-Mar-2014)
Anheuser-Busch InBev (ABI.BR, 72.87) Beiersdorf (BEIG.DE, 69.65) British American Tobacco (BATS.L, 3214.5p, NEUTRAL, TP 3500.0p) Carlsberg (CARLb.CO, Dkr522.0) Danone (DANO.PA, 49.44) Diageo (DGE.L, 1791.5p) Gudang Garam (GGRM.JK, Rp45,450) Heineken (HEIN.AS, 46.32) Henkel (HNKG_p.F, 76.5) ITC Ltd (ITC.BO, Rs355.9) Imperial Tobacco (IMT.L, 2418.0p, OUTPERFORM, TP 2700.0p) Japan Tobacco (2914.T, 3,030) KT&G Corp (033780.KS, W79,000) L'Oreal (OREP.PA, 116.35) Nestle (NESN.VX, SFr64.55) Oriflame Cosmetics (ORIsdb.ST, Skr152.7) Pernod-Ricard (PERP.PA, 80.39) Philip Morris International (PM.N, $80.43, NEUTRAL, TP $85.0) Reckitt Benckiser (RB.L, 4846.0p) SABMiller (SAB.L, 2802.5p) Souza Cruz (CRUZ3.SA, R$21.24) Swedish Match (SWMA.ST, Skr204.9) Unilever (UNc.AS, 27.81)
Disclosure Appendix
Important Global Disclosures
The analysts identified in this report each certify, with respect to the companies or securities that the individual analyzes, that (1) the views expressed in this report accurately reflect his or her personal views about all of the subject companies and securities and (2) no part of his or her compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report.
3-Year Price and Rating History for British American Tobacco (BATS.L)
BATS.L Closing Price Target Price
Date (p) (p) Rating
04-May-11 2653.50 2740.00 N
28-Jul-11 2857.00 2900.00
15-Sep-11 2755.50 3030.00 O
18-Nov-11 2888.00 3080.00
27-Feb-12 3159.00 3250.00
20-Apr-12 3244.00 3400.00
23-Oct-12 3164.00 3430.00
04-Jan-13 3174.50 3380.00
28-Feb-13 3434.50 3600.00
25-Apr-13 3591.00 3800.00
27-Jun-13 3439.00 3700.00
12-Dec-13 3142.50 3550.00
* Asterisk signifies initiation or assumption of coverage.
N EU T RA L
O U T PERFO RM
3-Year Price and Rating History for Imperial Tobacco (IMT.L)
IMT.L Closing Price Target Price
Date (p) (p) Rating
25-Mar-11 1896.00 2330.00 O
11-May-11 2197.00 2420.00
13-Jun-11 2056.00 2350.00
18-Nov-11 2275.00 2500.00
01-Mar-12 2534.00 2660.00
01-May-12 2556.00 2700.00
05-Nov-13 2382.00 2600.00
* Asterisk signifies initiation or assumption of coverage.
O U T PERFO RM
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24 March 2014
Tobacco 36
3-Year Price and Rating History for Philip Morris International (PM.N)
PM.N Closing Price Target Price
Date (US$) (US$) Rating
26-Apr-11 67.59 72.00 O
22-Jul-11 72.11 77.00
18-Nov-11 73.09 79.00
10-Feb-12 80.44 85.00
03-Apr-12 88.98 90.00 N
12-Feb-14 78.44 85.00
* Asterisk signifies initiation or assumption of coverage.
O U T PERFO RM
N EU T RA L
The analyst(s) responsible for preparing this research report received Compensation that is based upon various factors including Credit Suisse's total revenues, a portion of which are generated by Credit Suisse's investment banking activities
As of December 10, 2012 Analysts stock rating are defined as follows:
Outperform (O) : The stocks total return is expected to outperform the relevant benchmark*over the next 12 months.
Neutral (N) : The stocks total return is expected to be in line with the relevant benchmark* over the next 12 months.
Underperform (U) : The stocks total return is expected to underperform the relevant benchmark* over the next 12 months.
*Relevant benchmark by region: As of 10th December 2012, Japanese ratings are based on a stocks total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractiv e, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. As of 2nd October 2012, U.S. and Canadian as well as European ratings are based on a stocks total return relative to the analyst's coverage universe which consists of all companies covered by the analyst within the relevant sector, with Outperforms representing the most attractive, Neutrals the less attractive, and Underperforms the least attractive investment opportunities. For Latin Ame rican and non-Japan Asia stocks, ratings are based on a stocks total return relative to the average total return of the relevant country or regional benchmark; Australia, New Zealand are, and prior to 2nd October 2012 U.S. and Canadian ratings were based on (1) a stocks absolute total return potential to its current share price and (2) the relative attractiveness of a stocks total return potential within an analysts coverage universe. For Australian and New Zealand stocks, 12 -month rolling yield is incorporated in the absolute total return calculation and a 15% and a 7.5% threshold replace the 10-15% level in the Outperform and Underperform stock rating definitions, respectively. The 15% and 7.5% thresholds replace the +10-15% and -10-15% levels in the Neutral stock rating definition, respectively. Prior to 10th December 2012, Japanese ratings were based on a stocks total return relative to the average total return of the relevant country or regional benchmark.
Restricted (R) : In certain circumstances, Credit Suisse policy and/or applicable law and regulations preclude certain types of communications, including an investment recommendation, during the course of Credit Suisse's engagement in an investment banking transaction and in certain other circumstances.
Volatility Indicator [V] : A stock is defined as volatile if the stock price has moved up or down by 20% or more in a month in at least 8 of the past 24 months or the analyst expects significant volatility going forward.
Analysts sector weightings are distinct from analysts stock ratings and are based on the analysts expectations for the fundamentals and/or valuation of the sector* relative to the groups historic fundamentals and/or valuation:
Overweight : The analysts expectation for the sectors fundamentals and/or valuation is favorable over the next 12 months.
Market Weight : The analysts expectation for the sectors fundamentals and/or valuation is neutral over the next 12 months.
Underweight : The analysts expectation for the sectors fundamentals and/or valuation is cautious over the next 12 months.
*An analysts coverage sector consists of all companies covered by the analyst within the relevant sector. An analyst may cover multiple sectors.
Credit Suisse's distribution of stock ratings (and banking clients) is:
Global Ratings Distribution
Rating Versus universe (%) Of which banking clients (%)
Outperform/Buy* 43% (53% banking clients)
Neutral/Hold* 40% (50% banking clients)
Underperform/Sell* 14% (45% banking clients)
Restricted 2%
*For purposes of the NYSE and NASD ratings distribution disclosure requirements, our stock rat ings of Outperform, Neutral, and Underperform most closely correspond to Buy, Hold, and Sell, respectively; however, the meanings are not the same, as our stock ratings are determined on a relative basis. (Please refer to definitions above.) An investor's decision to buy or sell a security should be based on investment objectives, current holdings, and other individual factors.
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24 March 2014
Tobacco 37
Credit Suisses policy is to update research reports as it deems appropriate, based on developments with the subject company, the sector or the market that may have a material impact on the research views or opinions stated herein.
Credit Suisse's policy is only to publish investment research that is impartial, independent, clear, fair and not misleading. For more detail please refer to Credit Suisse's Policies for Managing Conflicts of Interest in connection with Investment Research: http://www.csfb.com/research and analytics/disclaimer/managing_conflicts_disclaimer.html
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Price Target: (12 months) for Imperial Tobacco (IMT.L)
Method: Our target price is derived using an APV with a 7year explicit forecast and a 8 year fade to a terminal growth rate of 0% and 50bps margin expansion per annum. We use a 8.5% cost of equity, 5.5% cost of debt and a 22% tax rate.
Risk: In addition to the risks of higher taxation, tougher regulation and volume decline in the developed world that all tobacco stocks face, the company-specific risks include: (a) deteriorating trading conditions in its key profit pools (UK, Germany, Spain, France and the US), (b) implementation of plain packaging in UK, (c) US federal excise tax hike, (d) taxation changes in fine cut tobacco, reducing and eliminating its tax advantage relative to cigarettes sooner than we expect, (e) potential liabilities from the investigation of the Office of Fair Trading in the UK market, and (f) reduced risk products achieve mainstream appeal (up-/downside risk)
Price Target: (12 months) for Philip Morris International (PM.N)
Method: Our target price of US$85 is derived using APV, with a 7yr explicit forecast period and an 8yr fade to a terminal growth rate of 0.5% and 50bps of margin expansion per annum driven by pricing. We use an 8.5% cost of capital, a 4.5% cost of debt and a 29.3% tax rate. Our target price implies the shares will maintain a current 12m fwd PE of 15x.
Risk: Risks to PM's achievement of our target price are: (1) the secular decline of the cigarette industries in developed countries, (2) Illicit product taking share from the legitimate trade (3) the potential for increased future regulation and taxation of cigarettes worldwide, (4) the significant dependence on the Marlboro brand, (5) increasing intolerance of smoking, (6) the volatility of earnings as a result of currency fluctuations (USD), and (7) reduced risk products achieving mainstream appeal (up-downside risk)
Price Target: (12 months) for British American Tobacco (BATS.L)
Method: We use an APV with an 8.5% cost of equity capital, 5% cost of debt, a 7-year explicit forecast window and an 8-year fade to 0.5% terminal
growth. Our target price implies that BAT shares will sustain a forward P/E multiple of roughly 15x in 12 months time
