Canadian bank RBC has downgraded both British American Tobacco plc (LON:BATS) and Imperial Brands PLC (LON:IMB) to ‘Underperform’ from ‘Sector Perform’ on predictions of lower margins as both firms sought to replace their core cigarette businesses with next-generation products (NGPs).
RBC’s analysts said they “expected relatively lower margin [NGPs] to continue to outgrow the core cigarette business”, which would lead to a “negative mix effect on profitability”, cutting their target prices for BAT to 3,400p from 3,900p and for Imperial to 2,400p from 2,900p respectively on the newly reduced margin expectations.
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The bank added that there was “no correlation” between the tobacco companies’ market dominance and their high margins, arguing that the high profitability was instead down to “historically insurmountable barriers to entry” in the industry such as regulation, economies of scale and tobacco’s controversial reputation.
RBC added that both companies’ plans to boost investment in their NGP businesses, with BAT planning make NGPs up to 30% of its revenues by 2030 from 4% in 2018n while Imperial intends to invest £300mln in NGPs in 2018 alone, posed a “material threat” to their profitability as the bank did not expect NGPs to reach the same high margins as the combustible cigarette business due to a higher fragmentation and lower concentration of the NGP market.
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Overall, RBC’s analysts said they expected the growth in NGPs would “erode the tobacco industry’s historically insurmountable barriers to entry” and by extension companies’ “high competitive concentration and profitability”.
As a result, they added that while sales were forecast to accelerate, this would be “more than offset” by a margin decline of 750 basis points by 2030 for both BAT and Imperial.
In mid-morning trading Monday, BAT shares were down 0.3% at 3,710.5p while Imperial shares were down 0.2% at 2,736p.