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.