Smoke signals from an unloved sector

Only a little over a decade after going their own way, Altria and Phillip Morris International (PMI) might be getting back together. The announcement will be welcome news to the investment banking community and to those looking for some distraction from near-constant coverage of geopolitical sabre rattling over Brexit and Sino-US trade tensions. In 2003, PMI rebranded itself as Altria and aimed to diversify away from cigarettes through a significant holding in Kraft, a move many perceived to be a feeble attempt to shake off the barrage of criticism around the health effects of smoking. By 2008, the two companies separated in an effort to insulate operations abroad from US tobacco. Altria became a US-only business, while PMI focused on the international stage, whilst maintaining the stake in Kraft to provide some protection against ongoing lawsuits and FDA scrutiny.

Fast-forward ten years. Both consumers and investors have become more aware of environmental issues, products’ impacts on society, and have more information at their fingertips to evaluate the company they are purchasing from. The widespread consideration of environmental, social, and governance (ESG) issues has led to the implementation of negative screening, and typically tobacco companies will be the first to feel the wrath of filters looking to remove companies that go against the ESG grain. However, despite being trapped in the “sin” bucket for several decades, both companies have been focusing on their next generation products (NGPs) in an effort to alleviate the strong stigma attached to smoking. Whilst litigation pressures may have eased from a decade ago, new threats remain in the form of restrictions on nicotine levels, a potential ban on menthol cigarettes, the ongoing debate on the dangers of NGPs, and attempting to reinvent a brand synonymous with cigarettes.

So why combine efforts again after a decade? In addition to an estimated annual cost saving of up to $1bn, as demand has fallen so too has criticism of tobacco diminished somewhat. While the two companies share the same cigarette portfolio, they have a complimentary products range in the alternatives space. The development of the IQOS product by PMI is unique, in the respect that the product will heat tobacco, as opposed to burning it. This stands in contrast to the vast majority of other businesses which have focused on promoting vaping as an alternative, of which Altria is part of. After more than a decade apart, it will be interesting to observe if a merger, new products and new marketing can breathe life into one of the most unloved sectors – or maybe it will all go up in smoke.

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UK Retail – a new year, but familiar struggles

The British Retail Consortium reported that December 2018 was the worst December sales performance for a decade, with total retail sales showing 0% year-on-year growth during the month. We’ve had a number of Christmas trading updates from UK retailers in the last few days, with the common theme that numbers were not as bad as gloomy investors had feared. This does not mean that the results were encouraging!

Tesco has been the relative winner with respectable Christmas trading in the UK. They say they remain on track to deliver on their margin targets (3% in H2 2019). However, although Q3 2018 like-for-like sales were up 0.7%, this was still a slowdown in growth from earlier in the year.

The Discounters once again took the spoils, and we are seeing food retailers responding to price gap widening by introducing further price cuts.

Next’s trading update was broadly in line with expectations. However, full-year profit guidance was marginally reduced, as we continue to see the traditional ‘bricks & mortar’ stores act as a drag on performance, with the shift to online continuing to impact margins.

John Lewis also had a reasonable update with 7-week sales growth of +1.4%, but the company reiterated its guidance that profits will fall substantially short of last year, with the Board considering whether to pay a staff bonus. The company will repay its 2019 maturity bond with a mix of cash and medium-term bank debt.

Marks and Spencer was more mixed, with food marginally ahead of guidance at -2.1% in Q3, and general merchandise softer than expectations at -2.4%. However, this was not as poor as many analysts had been expecting. The company is endeavouring to address the changing competitive landscape with a multi-year turnaround plan.

This year we have once again seen a decline of in-store customer numbers, reflecting the continuing strong growth of online shopping. In addition, heavy discounting, which has been a feature of Black Friday, now seems to have continued throughout December. Consumer confidence – as measured by market researcher GfK – was at a five-year low in November, which typically signals a scaling-back of discretionary purchases.

In the context of the broader credit market, retail bonds don’t look particularly cheap and there remain significant challenges to the sector – and that’s without even considering potential disruption caused by a disorderly Brexit! The first quarter of this year is unlikely to yield much fundamental improvement in the sector.

2019 may be a new year, but the same struggles remain.

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Eat, Drink and be Merry

The food retailers will be trying hard to tempt you over the coming festive season with their irresistible products, as UK food remains highly competitive. However the British Retail Consortium (BRC) has warned that Christmas dinner could be an expensive affair this year.

Data from the ONS shows food prices last month were up by 4.2% on 12 months earlier. Rising food prices can be negative for volumes and typically results in down-trading. Brexit may result in further food price hikes, labour shortages in the food industry and the loss of farmer subsidies.

Comparing the Consumer Price Index (CPI) to the Producer Price Index (PPI) shows that food CPI has increased less than food PPI – suggesting that supermarkets have not passed all the inflation on to customers and have absorbed part of it. Indeed Tesco and Waitrose have noted this, which is positive for volumes but hurts profitability.

The discounters are not immune to this either. Aldi has felt the margin squeeze as a result of its efforts to keep its prices lower than the Big Four and improve product quality, as the larger grocers have tried to become more price competitive.

We have seen many proactive strategies to improve brand, price position and customer in-store experience from the Big Four. Sainsbury’s acquired Home Retail Group while Morrisons has created alliances with both Amazon and McColl’s. The CMA (the Competition and Markets Authority, the UK’s competition watchdog) has perhaps given Tesco some seasonal cheer unveiling its provisional findings on the potential merger between Tesco and Booker, stating that it does not see any significant obstacles to competition. The merger of Tesco and Booker would create a group with a market share of close to 30% in the UK convenience segment (Booker runs more than 5,000 stores) – a segment that is likely to gain importance in the next few years as changes in consumer habits indicate huge potential in this area.

Tesco remains the leader in the UK, with a market share of 28%, but has faced fierce competition from discounters as well as the other major players. There will be no relief over the important festive period. The discounters continue to grow, Asda is recovering from its underperformance, and Amazon is increasing competition online. Increased competition means that it is unlikely that UK grocery retailers’ margins will return to the levels of 2013 and earlier.

In early January we will find out just how much goodwill has been shown to the sector.

Winter is coming

UK clothing and sales volume growth has been robust year-to-date. Latest data from Kantar Worldpanel (to 24 Sept 2017) shows the market has improved marginally year-on-year (yoy) for the fourth year in a row. 12-week yoy growth at +1.5% is the strongest seen for around 2-years, although this is likely to have been boosted by favourable weather and previously weak same-store sales.

The year-to-date yoy growth in clothing retail sales has been highly dependent on the weakness of sales last year, when the weather was extremely unfavourable. Although it seems likely that weather conditions will be more befitting to the season for the start of the Autumn/Winter clothing-retailing season than last year, clothing retail sales weren’t all that weak in early autumn last year so the year-on-year comparison will not be as easy as it has been for Spring/Summer.

The Autumn/Winter season has appeared to be off to a strong start with the likes of M&S, Debenhams and Primark seeing better market share trends. Encouragingly, the data has shown improved sales of products at their full price, most notably at Next and M&S. However, this relatively positive backdrop looks to be fully reflected in bond prices. Pressure on disposable income appears to have returned in the near term (The Asda Income Tracker is broadly flat yoy), and with a low household savings ratio, it seems premature to expect a sustained improvement. Additionally, capacity growth continues and the overarching pressure from online retailers continues to strain the industry.

With October trends likely to be weaker, and the upcoming competitive pressures of Black Friday and Christmas trading, I would expect retailers to maintain some caution.

UK retail comparable sales get tougher over the next few months – winter is coming.

Where there’s smoke…

The US Food and Drug Administration (FDA) recently announced that it would seek public input to potentially lower nicotine levels in combustible cigarettes to non-addictive levels. The FDA took over tobacco regulation in 2009 and has the authority by law to reduce nicotine in tobacco products. The agency want to make cigarettes less addictive and encourage “Next Generation Products” by making the authorisation process easier – banning menthol cigarettes for example is also on its agenda.

In the past, the FDA has moved very slowly on tobacco. From the outset the FDA had authorisation to regulate cigars, but it only began to do so in 2016 – seven years after being granted that authority. The FDA is now in the process of changing rules around this governance; these changes will create a new programme with a multi-year time scale as it must consider the scientific evidence, write robust rules and finally implement them.

The market is understandably apprehensive about the proposed plan, but it will take a few years for the FDA to move through its mandated rulemaking process and yet longer to get to an effective date of implementation. Many questions still remain – such as “what constitutes non-addictive nicotine levels?” and “how will that be scientifically proven?”

Separately from this, British American Tobacco (BAT) has just completed the Reynolds acquisition in the United States, meaning 35% of its EBIT now comes from US cigarettes. Part of the attractiveness of the takeover was the exposure to the US market where regulation and tax has been benign for some time. Do the reasons for the deal look less appealing now? BAT owns the VUSE electronic cigarette brand which has the largest market share in the US. In an environment where Next Generation Products have more regulatory support this puts BAT in a good starting position; BAT also has strong e-vapour products in the rest of the world and these could be quickly introduced into the US market.

BAT’s yield curve has rightly steepened and is set to remain elevated given the potential increased regulatory risk. The tobacco sector also had a large technical overhang with the well-anticipated $20bn supply across currencies from BAT to fund the Reynolds American transaction. With the successful completion of that bond refinancing, BAT is committed to maintaining a solid investment grade credit rating with the company specifically targeting a high BBB rating. BAT’s management have stated it will not pursue share buybacks or debt-financed M&A until leverage returns to appropriate levels.

Volatility creates opportunity and recent weakness has been an opportunity to add at more attractive spreads. Gaining exposure to robust cash flow generative assets at the trough in credit ratings, with significant deleveraging to come makes sense. There is plenty smoke left in this sector and maybe even a little fire.

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