Will Europe Burn Tobacco Profits?

The Continent's smoking bans haven't really affected cigarette makers' earnings, but the crackdown is spreading and sales are down

By Beth Carney

Ireland's nationwide ban on smoking in pubs and restaurants has had a dramatic impact since being enacted 10 months ago. Cigarette sales are down. Pubs are no longer smoky, and people are generally pleased with the change. Ireland's Office of Tobacco Control reported in December that compliance with the ban since it was implemented has been 94% -- an astonishing rate in a country whose pubs were once known for their thick haze of smoke.

What's still unclear, however, is how the smoking ban will affect tobacco companies' bottom line. As governments in Western Europe crack down on smoking through initiatives ranging from bans to higher taxes, cigarette makers have so far been largely unaffected by the changes. Yet some analysts say the cumulative effect of these measures may start to catch up with the enormously profitable tobacco concerns soon.

Michael Smith, analyst with J.P. Morgan, predicts that the stocks of global tobacco players are entering a year-long period of 10% to 20% underperformance, after outperforming the market for four years. Although litigation remains a risk, he writes, "regulation is becoming a key driver of cash flow."


  Indeed, Credit Suisse First Boston warns that regulation's impact has not been figured into the current prices of tobacco shares. European tobacco stocks have outperformed the market by 11% in the past year, but the bank predicts that trend will end. The stocks have a downside risk of 20% thanks to "negative regulatory news flow," according to a CSFB report. Cigarette makers with heavy European exposure include Britain's Gallaher Group (GLH ), the Franco-Spanish Altadis, and Britain's Imperial Tobacco (ITY ).

The Old World may be associated with smoke-filled cafes and a relaxed attitude toward lighting up, but European governments are becoming increasingly tough on smoking. Last week, the air cleared up in most of Italy's espresso bars when a law came into effect barring smoking in all workplaces, including restaurants and bars, except at the relatively few that that provide separate smoking rooms with special ventilation. Malta and Norway also enacted similar bans last year.

The crackdown is gaining momentum: Sweden will be implementing a ban this summer, and restrictions have been proposed in Britain. For their part, France and Germany have discouraged tobacco usage in recent years by hiking cigarette taxes. And most European countries have barred tobacco advertising entirely following an EU directive in 2003.


  The regulations have had an immediate impact on volume of cigarettes sold, which is already on the decline in many Western European markets. According to Euromonitor International, a market-research firm, sales of smokes in Ireland fell 8.7% last year, when the ban was implemented, after declining 3.4% in 2003, and 1.2% in 2002. France and Germany experienced even sharper drops after the tax increases -- a 13.6% fall in 2003 and 15% in 2004 in France, and 12.8% in Germany last year.

So far, however, cigarette makers' profits are holding up, largely because tobacco concerns typically raise their prices when volume decreases. "Could [the government initiative to discourage smoking] affect volume? Yes. Will it affect profit? No," said David Adelman, an analyst with Morgan Stanley in New York.

Gallaher Tobacco, the market leader in Ireland, reported that Irish sales dropped 10.7% from January and October of last year. Before the ban came into effect, however, when the government increased cigarette duty, the company hiked its prices so that its take on the sale of smokes was 5% higher. Because of the higher duty and the fact that some of the volume decline was related to the one-time hit as pubs removed their vending machines, Claire Jenkins, director of investor relations said: "it's impossible to say what the impact of the smoking ban is."


  However, Jenkins contends that the ban "won't materially affect the business." The company reported that overall group volumes were up 3.9% during the10 month period, thanks to strong growth in Eastern Europe and the former Soviet Union. In its last financial statement, the group reported a $467 million (250 million pounds) profit in the six months preceding June, up 4.4% from the same period the previous year. Total value of sales for the half-year were $8.72 billion, up 8% from $8.08 billion from the year-ago figures.

The ability to seek out new markets where regulation is looser or smoking habits are still entrenched has long benefited global tobacco vendors. "They're aggressively going after developing markets. There's a huge demand already in Africa, Southeast Asia, and Eastern Europe, and the major brands are moving in and replacing many of the smaller, localized brands," says Dan Ahrens, president of's Vice Fund, which invests in tobacco, alcohol, gaming, and defense-industry stocks. The fund returned 24% last year, compared to 11% from the Standard & Poor's 500-stock index.

Analysts also point out that the tobacco industry has been successfully coping with creeping restrictions on smoking for decades. Moreover, cigarette makers' operating margins are much higher than those of most consumer-products outfits, at times higher than 50%. Christopher Wickham, an analyst at Lehman Brothers in London, notes that tobacco concerns are "hugely, hugely profitable." In Britain alone, despite cigarette taxes that are among the highest in Europe, cigarette companies' combined annual profits are nearly $2 billion.


  Still, the new regulations seem bound to have detrimental consequences for tobacco groups over time. For example, required health warning labels reduce the value of branding, Smith notes. Smokers can always light up at home, but public smoking bans eliminate an opportunity for them to develop brand loyalty through social groups. And in the long term, the bans could prevent young adults from picking up the habit.

Zora Milenkovic, head of Euromonitor's tobacco research, also says regulation's impact on cigarette makers will increase, given consumption patterns. One test will come as Eastern European countries join the European Union, she says, and are required to adopt EU-recommended cigarette taxes and advertising rules. Currently in Eastern Europe, the sales volume of cigarettes are still growing. "It's a lucrative market," she says. Whether that market -- and the Europe in general -- will stay that way is uncertain.

Carney is a reporter for BusinessWeek Online in London

Edited by Thane Peterson

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