Moody’s: Slowing operating profit growth likely to keep European tobacco industry outlook stable till 2015

Press release: The outlook for the European tobacco industry will remain stable over the next 12-18 months, reflecting an expected slowing of operating profit growth to around 4.5%-5.5% versus the previous expectation of 7% growth, says Moody’s in its latest Industry Outlook report on the sector published today. Moody’s changed the outlook for the European tobacco industry to stable from positive in June 2013.

The new report, entitled “European Tobacco Industry Profit Growth to Slow as Volume Decline Accelerates”, is now available on www.moodys.com. Moody’s subscribers can access this report via the link provided at the end of this press release.

“We expect to see a further acceleration in declining cigarette sales in the next 12-18 months in most European markets. Volume declines may be larger in more profitable markets, which will have a greater impact on overall industry profitability,” says Paolo Leschiutta, a Vice President – Senior Credit Officer in Moody’s Corporate Finance Group and author of the report. “Overall, increased regulatory pressure will likely continue to weigh on the operating profits of tobacco companies into 2015.”

Within Europe, Moody’s expects the decline in cigarette volumes to be greater in southern European countries, where the rating agency expects no, or very slow, economic growth in the period. In addition, Moody’s notes that regulatory pressure has increased in the past year, including a smoking ban in Russia, which the rating agency believes will have a significant short-term impact on volumes.

Tobacco manufacturers will probably increase prices to offset increasing pressure on volumes. Price inelasticity remains good, but the current market conditions will constrain price increases.

Moody’s expects that developing market growth will help offset sluggish mature markets. Philip Morris International Inc. (PMI, A2 stable) and British American Tobacco plc (BAT, A3 stable) should benefit from their greater exposure to emerging markets and from their earlier starts in investing in non-traditional products. Imperial Tobacco Group plc (Baa3 positive) and Swedish Match AB (Baa2 stable) are more exposed to mature markets but both have diversified products or value brands, which will help reduce the impact of sales declines in those markets.

The nascent e-cigarette market could add to competitive pressure in the industry. However, in the next two to three years Moody’s expects these products to represent only 1%-2% of the global cigarette market in terms of volumes, and an even smaller proportion in value terms. Some issuers are moving into the segment via acquisitions in the case of BAT, or product investment (PMI).

Moody’s notes that the industry remains exposed to a significant degree of event risk due to the companies’ appetite for acquisitions and the industry’s historical consolidation rate. However, Moody’s expects issuers to moderate their historically aggressive shareholder policies if they make large acquisitions or if operating performance declines. The risk of US litigation, which the rating agency believes BAT remains partially exposed to, remains acute in terms of the potential punitive damage awards.

Moody’s considers that the outlook has more upside potential than downside. If issuers can offset the industry’s short-term challenges with growth in emerging markets, possible small acquisitions and price increases, then profit growth might exceed 6% and Moody’s could consider changing the outlook back to positive. Moody’s would change the outlook to negative if operating profit contracted or there was a dramatic regulatory change or litigation.