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Tobacco's Existential Crisis

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Michael Deich, Investment Grade Fixed Income Credit Analyst and Stewart D. Taylor, Investment Grade Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - Tobacco is in crisis. New regulations, social change, and a growing market in cigarette alternatives are pressuring top-line growth while growing expenses including ongoing litigation costs are pressuring bottom lines. Our outlook for investment in tobacco company investment grade corporate bonds is becoming progressively more cautious.

      Equity investors have traditionally viewed tobacco as a low beta consumer staple that distributed attractive dividends. These companies enjoyed strong margins, good cash flows, and high profitability. Importantly they also had a captive customer base. Fixed income investors focused on the good debt metrics and the ability to service and retire debt. We think this benign view will change as profitability begins to decline.

      Volume Declines: Developed market cigarette sales volumes are falling. Aggressive public anti-smoking campaigns, demographic change, and awareness of tobacco's health impacts are taking a toll on revenue. In 2016, volumes were down -2.5%. In 2017 volume declined an additional -4.0% and in 2018 declines were -4.5%. Altria, one of the world's largest tobacco companies, reported it is expecting annual declines of -4.0% to 5.0% through 2023, according to company reports released in first quarter 2019. Additionally, regressive taxes combined with persistent incremental price increases by the tobacco companies have made smoking a very expensive habit. The average cost of a pack of cigarettes in the US is $5.51 with costs in most states between $6.00 and $8.00.

      Tobacco

      Regulatory environment: The regulatory environment is hostile. Recent Food and Drug Administration (FDA) proposals include requirements to reduce cigarette nicotine content to non-addictive levels, banning all menthol flavoring from tobacco products and raising the minimum age to purchase cigarettes from 18 to 21. The perverse impact of decades of intense regulation encouraged industry consolidation and kept barriers to entry high. This supported margins and cash flows. However, the industry has consolidated as much as can be expected. We believe that the favorable margin impacts due to regulation and subsequent consolidation have mostly run their course.

      Other Business Lines: Tobacco companies are attempting to diversify into less harmful nicotine delivery systems and cannabis. Altria recently purchased a 35% stake in JULL and a 45% stake in marijuana producer Cronos, a leading cannabis grower in Canada. Other companies are making similar acquisitions. While smokeless and vaping products like JUUL are increasingly popular, they have their own risks and regulatory uncertainties. Importantly, margins on these products are much lower. In addition, while current volumes are growing, they aren't growing fast enough to compensate for the loss of cigarette volume.

      Opportunities: To be sure, there are positives associated with the industry. Balance sheets are in fair condition and companies have the option of cutting back on their currently high dividends should business conditions deteriorate. On the regulatory front, the FDA has begun to view tobacco product regulation more granularly. For instance, cigarettes, being the highest risk, are receiving stricter regulation than safer nicotine pouches and gums. Additionally, large tobacco companies are expanding rapidly into emerging markets where there are fewer restrictions, growing levels of disposable income and less social pressure.

      Recent Bond Performance: Since 2017 equity and bond returns have lagged broader market indices. However, over the first half of 2019 the ICE BofA/Merrill Lynch US Tobacco Corporate Index (T0A0) outperformed, returning 11.30%, compared to 9.60% for the broader ICE BofA/Merrill Lynch 1-10 Year U.S. Corporate Index (C0A0). Falling rates drove much of the performance, but credit spreads also narrowed.

      Bottom line: While we see little danger of a near-term disaster for the tobacco industry, we think the sector is fully valued and facing existential crisis.