Despite Negative Trend, We See Value in Big Tobacco

We've lowered our moat trend ratings for British American Tobacco, Imperial Brands, and Philip Morris International to negative from stable due to the evolution in the market for next generation products.

Initially, we had assumed that the cigarette brand equity of tobacco manufacturers was transferable to next generation products, and early signs supported our assumption. But recent evidence suggests otherwise. Greater adoption of cigarette alternatives now seems more likely to erode big tobacco's cost advantage, pose risks to margins from volume declines, and hit overall returns on capital.

Although we have become incrementally more concerned about moats and margins in the tobacco space, we still believe in Big Tobacco's wide economic moats. Though it may seem counterintuitive in a declining industry, we have conviction that our wide-moat ratings are appropriate, because we believe Big Tobacco is very likely to continue generating excess returns on invested capital for the next 20 years. Cigarette pricing remains strong, and most markets have headroom for multiyear price increases that should more than offset volume declines.

The market appears to be pricing in a dire scenario for the industry and is far too pessimistic, in our view. In fact, we think there is value in tobacco stocks today. Our current picks in the market are Imperial Brands and Phillip Morris International. Both of these low-uncertainty stocks are trading at a greater than 20% discount to our fair value estimates.