Vontobel Viewpoints FDA New Direction on Tobacco Our Take

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1 Quality Growth Boutique TM Vontobel Viewpoints On July 28, 2017, the new Commissioner of the U.S. Food and Drug Administration (FDA), Scott Gottlieb, surprised the markets by launching a consultation paper calling for a new approach to tobacco regulation. Fundamentally, the idea is to separate nicotine, the addictive substance, from the burning of tobacco, which releases the smoke particles attributed to health damage. The goal is to establish a framework to regulate the consumption of nicotine that will cover delivery methods including both traditional cigarettes and the new reduced harm next generation products (NGPs) such as e-cigarettes and heat-not-burn (HNB) devices. The FDA noted the potential for innovation to offer less harmful products and that they are proposing to regulate nicotine rather than attempt to ban it. An initial suggestion the paper made is to lower the nicotine within traditional cigarettes to minimally or non-addictive levels, however not necessarily for non-combustible NGPs. The paper also touched on the risk of fl avors appealing to underage smokers a potential warning aimed at flavors in vapor products as well as menthol cigarettes. Our initial impression is this appears to be a sensible launch aimed at reducing damage to consumer health rather than an attack on any particular company or industry. We think action by the FDA focused on nicotine will help get past an ideological impasse in the U.S., which has pitted those who believe nicotine is fundamentally bad at any levels, against those who believe less impactful products have a place in the economy. This paper appears to side with the latter. We realize the FDA action will be closely watched by many other regulators and has the potential to reshape demand across large parts of the global tobacco market. Our view is that offering consumers a step that would allow the continued choice of nicotine consumption, while also reducing health costs to society, is less likely to lead to long drawn-out legal battles with the tobacco companies that could stall any change. However, we are cautious. In regulatory terms, we are always wary of slippery slopes and there is the potential this could be the fi rst of a multi-move plan by regulators. If a later step involved regulating nicotine limits (as it currently is in the EU) to very low limits, this would be a negative for companies selling into the market. In this document the Commissioner of the FDA outlined his view that nicotine is not the cause of health damage; however, he left the door open calling nicotine by no means a completely safe and benign compound. Vontobel Asset Management Also, enforcement will be a major consideration. According to the World Health Organization, there is not yet an established level of nicotine that leads to addiction. If a low maximum level was introduced to stop new consumers taking up smoking, but offered existing smokers amounts below current consumption patterns, one has to think through, how might consumers react consume more cigarettes? create demand for black market supplies? switch to alternative methods of consumption? The FDA paper appears to support the last outcome. However, enforcement to hold back surging demand for illicit cigarettes can be a challenge as we have seen in markets as varied as Brazil, India and the UK. A surge in illicit cigarettes damages the sale of legally produced products and can lead to the consumption of unregulated lower quality products and falls in tax revenue. Euromonitor International estimates the black market for cigarettes globally accounts for some 460 billion cigarettes per year. The U.S. had a bad experience with prohibition of alcohol and policy makers are aware of this history. Also, there already are issues with Native American tribes selling untaxed cigarettes as a route for illicit cigarettes already exists, regulators would be wary of encouraging this. A market shift is already underway shifting consumption from tobacco to nicotine and we see this FDA push as reinforcing this. As a consequence, we believe companies with a well-developed portfolio of reduced risk products are better positioned to take considerable market share. The leaders in NGPs are Philip Morris International (PMI) and British American Tobacco (BAT), as they both have developed a full suite of technologies. Page 1

2 Initial Market Reaction The market s initial reaction was a sharp sell-off in the share prices of the major tobacco companies. However, the market soon differentiated between those with and without U.S. sales exposure: Philip Morris International, which has no sales in the U.S., ended the day of the FDA announcement without any impact on its share price. The chart below shows performance between the beginning of the year and end of day June 28, Source: Bloomberg We believe an important contributor to the nervous selling around the FDA s paper has been the re-rating of the tobacco sector over the past few years. A number of the market leaders have been trading towards the top of their historical PE ranges. Over the past five or six years, PE expansion was also a reflection of improved visibility surrounding litigation in the U.S., and the effects of additional regulations around the world dissipated. Additionally the advent of NGPs pushed up valuations as well, as they have the potential to change the long-term dynamics of the industry. Source: FactSet Page 2

3 Action Taken Over the past year we have reduced our exposure to tobacco companies within our strategies primarily due to rising valuations. Some of the re-rating for BAT and PMI may be due to the high proportion of income they generated outside of the U.S. against a strong U.S. dollar. However, the re-rating has been pronounced and we have taken advantage of these conditions to reduce exposure. Within our International Equity Strategy, we also exited Imperial Brands, Japan Tobacco (JT) and ITC over the past year. It has become increasingly clear Imperial has no interest in developing a HNB product and future growth does not justify its current valuation. While JT has its hybrid Ploom Tech product, they have been slow to the market and are facing strong competition in their home market from both PMI and BAT. Neither Imperial Brands nor JT were held in our Global Equity Strategy over the past year. Within the Emerging Markets portfolio, we trimmed ITC (India) on strong performance and reduced our holding of BAT following the agreed deal to acquire Reynolds American which will reduce the proportion of income from emerging markets. Source: FactSet Strategy weights are based on the representative portfolios Next Generation Products These products are designed to deliver nicotine while releasing considerably fewer, or no, chemicals generated from the burning of tobacco that can be bad for consumers. This has the benefi t of helping traditional cigarette smokers who want to quit, give up the habit. But also to be used by people who choose to consume the product. The benefi t of NGPs in helping smokers give up their habit have been illustrated by studies such as the 2016 research published by the BMJ on EU smokers. The study showed that 23.5% of those that stopped smoking tobacco completely had used e-cigarettes as a cessation device. There are a range of different products that manufacturers have on the market or are soon to launch. NGP products fall into three main categories: Vapor: electric devices that vaporizes a solution containing nicotine, propylene glycol and sometimes flavors Heat-Not-Burn: devices that heat, but not burn, tobacco releasing nicotine and some flavor Hybrids: combination of e-liquid with tobacco where a heated vapor passes through tobacco for flavoring and nicotine Page 3

4 Markets Where iqos (heat-not-burn product) Has Been Launched Source: Philip Morris International The market for HNB products appears to offer the solid potential worldwide for the tobacco companies currently. However, none have yet been approved by the FDA for sale in the U.S. The leading HNB manufacturer is PMI, followed by BAT. PMI has launched its iqos heat-not-burn product nationally in Japan, as well as 27 other countries. Its market share has grown quickly in Japan where it was first launched in By July 2017, iqos had a 12.7% nationwide market share by volume through convenience stores in Japan, and 10% overall Japanese market share in 2Q17. BAT has also successfully launched Glo, its HNB product in Japan, although with a later launch date and therefore has a smaller market share. However, given the initial success of iqos and Glo in Japan and the rapid market share gains of these products in a number of other markets, we believe NGPs will be important contributors to future earnings growth for these companies. Capacity would be an issue if the market moved quickly given the huge volumes of cigarettes sold annually across the world. PMI is the most advanced not only in NGP market penetration but also capacity planning. Earlier this month PMI announced a US$570 million investment to produce iqos HeatSticks, also called HEETS in some markets (the tobacco used inside iqos), in its Romanian factory bringing its announced planned HeatStick production capacity to a significant 150 billion units by For context, this compares to a total of 123 billion cigarettes sold by Altria in 2016, and illustrates the scale management is thinking in. However, BAT has been investing into South Korea as its Asian export hub for Neosticks (the tobacco used inside Glo), and the company plans to quadruple capacity in In terms of profitability, it is still early to tell what sort of margins the manufacturers will make from the NGPs given the early stage of volume sales. However, we believe the potential is for margins to reach or exceed those of cigarettes when priced in line with their cigarette equivalent price points when at scale (premium brand vs premium brand) which would be encouraging for earnings growth. However, it is early days and we maintain our forecasts on the conservative end of the range. Currently, it appears taxation is a margin driver for NGP products. While tax authorities are often not keen to give out tobacco rates by product, researchers from Redburn found the median excise tax rate in eight geographies for PMI s iqos was 60% lower than those on premium cigarettes in 2016 including 20% lower in Japan, 59% in Italy and 80% in Latvia. For premium products such as iqos that retails at a similar price to premium cigarettes, this provides room for healthy margins. Page 4

5 Source: Company sources Note: Hybrid: solution and heated tobacco. Vapor includes e-cigarettes. Outlook As long-term investors into this industry, we have seen many periods of unattractive headlines in fact, it s hard to think of many positive headlines about tobacco. However, for those investors that have given them patience, we believe the managements of some of these companies have delivered remarkable returns. An important test of durability we look for is a company able to sell a product wanted by customers and does not fall foul of regulations set by the government. We will continue to closely monitor market developments, both in terms of regulatory outlook, and the adoption rates of the NGPs as test markets mature, and as the products are launched in new markets. We believe the companies with well-developed NGP portfolios, and distribution platforms, are well placed to adapt to a changing market environment rather than fight it. British American Tobacco BAT is the world s second largest tobacco company by revenue, following the recent acquisition of Reynolds American behind China National Tobacco. Founded in 1902 and listed in 1912, the company sells its products into 200 countries and is the market leading tobacco company in 55 countries. Its brands include Dunhill, Kent, Lucky Strike and Rothmans. BAT s Next Generation Products are focused on Vapor (#1 market share worldwide with the Vype acquisition) and HNB (Glo) platforms. With 2016 revenues of US$19.9 bn and a net profi t of US$6.3 bn, the company generates substantial cash flow, which it has returned in large amounts to shareholders in the form of dividends and share buybacks. On July 25, 2017, the company finalized the US$49bn purchase of the 58% of Reynolds American it did not already own. Reynolds generates 100% of its revenue from the U.S. The deal was relatively expensive at 9.1x EV/EBITDA; however, we were fine with the price given the company is so well understood by management, the ability for the companies to combine their R&D programs, and room for further price rises in the U.S. The company also owns 31% of ITC Ltd. in India. Philip Morris International PMI is the world s third largest cigarette manufacturer, spun-off from Altria (U.S.) in The company has no revenue exposure to the U.S. and held a 28% global market share (excluding China and the U.S.) in 2Q17. The company s leading brands are Marlboro, L&M, Parliament, Bond and Chesterfield, as well as a variety of local brands. In 2016 the company reported revenue of US$26.7bn and a net profi t of US$6.9bn. PMI has aggressively returned cash to shareholders, both through dividends and share buybacks. NGPs accounted for 8.9% of the company s 2Q17 revenue, rising over 12 months from just 1.8% in 2Q16. As of July 2, 2017, the iqos HNB product alone had a 12.7% national market share in Japan, by volume, through convenience stores. In 2016 PMI assigned a strategic framework with Altria to include the sharing of research, development and technology. In 4Q16 PMI submitted a Modified Risk Tobacco Product (MRTP) application for an HNB product with the FDA. July 31, 2017 Authored by: Sudhir Roc-Sennett Page 5

6 Disclosures and Disclaimers Past performance is not indicative of future results. Any companies described in this commentary may or may not currently represent a position in our client portfolios. Also, any sector and industry weights described in the commentary may or may not have changed since the writing of this commentary. The information and methodology described in this commentary should not be construed as a recommendation to purchase or sell securities. Any projections, forecasts or estimates contained in this commentary are based on a variety of estimates and assumptions. There can be no assurance that the estimates or assumptions made will prove accurate, and actual results may differ materially. The inclusion of projections or forecasts should not be regarded as an indication that Vontobel considers the projections or forecasts to be reliable predictors of future events, and they should not be relied upon as such. In the event a company described in this commentary is a position in client portfolios, the securities identifi ed and described do not represent all of the securities purchased, sold or recommended. The reader should not assume that an investment in any securities identifi ed was or will be profi table or that investment recommendations or investment decisions we make in the future will be profi table Vontobel Asset Management, Inc. All Rights Reserved Mutual funds distributed by VP Distributors, LLC, member FINRA and subsidiary of Virtus Investment Partners, Inc. To learn more about Vontobel, please visit or call Page 6