Tobacco stocks seem likely to move lower today following media reports that the Biden administration is considering lowering the nicotine and menthol levels in cigarettes in the U.S. The introduction of such measures does not form our base-case assumption for the purposes of forecasting cash flows, but it is one of the ESG risks we have identified, and is captured in our bear-case valuations. There is little evidence to suggest the change in administration has increased the probability of these events occurring, so we maintain our valuations and wide moat and negative trend ratings for the cigarette makers with exposure to the U.S. cigarette market: Altria (MO), British American Tobacco (BATS) and (IMB). Negative headlines such as this have spooked investors since 2017, and the tobacco group is undervalued relative to our estimate of intrinsic value. Our picks remain Philip Morris International (PM), whose exposure to the U.S. is limited to a revenue share of its market-leading reduced risk portfolio, and Imperial Brands, which trades at under 10 times forward earnings and pays a dividend yield of 9%.
The threat of a menthol ban has been an overhang for many years, and nicotine level reductions were mooted by hawkish FDA commissioner Scott Gottlieb in 2017. Menthol is a compound added to cigarettes to ease throat irritation caused by cigarette smoke, and is said to attract young and female consumers, as well as African American smokers. Proponents of prohibition argue that it could lower the rate of smoking initiation in these groups. The menthol category represented 29% of the total U.S. market by volume in 2019, according to Euromonitor. Nicotine is in itself of limited harm if consumed in moderate quantities, but as the addictive substance in cigarettes, it suppresses the cessation rate. If it were to be limited in cigarettes to minimally or even non-addictive levels, the secular decline rate on cigarette volumes could accelerate.
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