Tobacco's existential crisis... continued

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      By Michael DeichInvestment Grade Fixed Income Credit Analyst and Milo TongInvestment Grade Fixed Income Credit Analyst, Eaton Vance Management

      Boston - Tobacco is in crisis.

      In July, we made the case that new regulation, social change and the growing market in cigarette alternatives would continue to reduce industry volumes and revenues. We also made the case that tobacco companies are diversifying into less harmful nicotine delivery systems like e-cigarettes and cannabis.

      Since July, worsening volume projections, adverse regulatory developments surrounding vaping products and merger talks between Altria and Phillip Morris have strengthened our conviction. 

      Worsening volume projections: Volumes are declining faster than expected; in early August, British American Tobacco reported U.S. volume declines of -5.4% in the first half of 2019, while decreasing their full-year estimate to -5.5%. Similar projections from Altria suggest volumes are declining at an accelerating rate.

      Adverse regulatory developments: Several recent health studies suggest vaping may be much more harmful than thought. Health authorities are urging people to stop using vape products while they investigate deaths and numerous severe lung injuries related to their use. The injuries may be the result of additives or THC, but it is too soon to be definitive. More distressingly, President Trump has suggested that his administration may ban all non-tobacco vaping products.

      • In an attempt to reduce youth vaping, multiple states have either announced bans or introduced legislation to ban flavored e-cigarettes. Many states have opened investigations into the health hazards of vaping.
      • Internationally, India has banned electronic cigarettes and Juul Labs products have disappeared from Chinese electronic marketplaces.
      • Networks such as CBS, WarnerMedia and Viacom have dropped all e-cigarette advertising.

      Merger talks between Altria and Phillip Morris: Phillip Morris and Altria confirmed that they were in talks to re-merge, which would have created interesting economies of scale. However, on the same day that Altria-backed Juul Labs fired its CEO and suspended advertising, the companies announced that the talks had ended.1

      To be sure, the positives we outlined in July remain intact. Low leverage, decent balance sheets and flexibility surrounding dividends have cushioned the industry. Despite the lower volumes, revenues and profits have continued to grow. Although the industry may not benefit from the diversification away from tobacco to electronic delivery systems, many users will shift back to cigarettes, which still make up approximately 90% of global nicotine retail value.

      Bottom line: The conclusion we reached in July still holds. While we see little danger of a near-term bond default, we believe that the sector is fully valued and facing an existential crisis. Recent events only serve to strengthen that view.