Bat Shifts Its Aim East

The tobacco giant has found new markets in emerging economies.

The biggest fear for tobacco investors -- apart from the health risks of consuming their own products -- is that one day these global giants will be legislated out of existence.

I think this fear is misguided, and the recent behavior of the world's No. 2 tobacco company, British American Tobacco (NYS: BTI) , demonstrates why.

Peak tobacco?
Much like "peak oil," I believe that suggestions of imminent decline in the global tobacco market are massively exaggerated. BAT sold 705 billion cigarettes in 2011 at an operating margin of 35.8%, delivering 4.7 billion pounds of profits -- a 9% increase in 2010, even though volumes were down 0.4%.

In its Q1 results, published today, BAT has reported a 0.7% increase in organic volumes, coupled with a 4% increase in revenue at current exchange rates. Sales growth was driven mainly by Brazil, the Middle East, Denmark, Bangladesh, and Vietnam, according to BAT.

Indian takeaway
India isn't featured much in BAT's reporting, but that's not because the company doesn't have any exposure to India's 275 million smokers -- 50% of whom do not know that smoking can cause strokes, according to a recent report by the World Heart Federation.

BAT owns 25.4% of ITC, formerly known as Indian Tobacco Company. ITC is a fast-growing conglomerate that has the lion's share of the Indian cigarette market and sells some BAT brands, such as Lucky Strike, under license.

ITC also has a number of fast-growing consumer goods brands, and its 2010 to 2011 turnover was 3.6 billion pounds, with post-tax profits of 586 million pounds. A single line in BAT's annual accounts shows that ITC made a contribution of 218 million pounds in 2011 -- equal to nearly 5% of BAT's operating profits.

Secret weapon
Big tobacco's pricing power and profitability are driven by the global appeal of its brands, especially in emerging markets where they are seen as aspirational and attract a price premium over cheaper local products.

Its fear of losing this advantage has been highlighted by its ferocious opposition to a new Australian law that will require tobacco products to be sold in plain packaging from December of this year.

The outcome from the resulting court case is still pending, but a number of Western governments are watching carefully to see whether Australia succeeds in implementing this law. If it does, others will follow.

Emerging fears
Plain-packaging laws could present a serious problem for tobacco marketers in emerging markets. However, I don't expect this to happen, thanks to big tobacco's other advantage: its ability to spend almost limitless amounts on lobbyists and lawyers.

A case in point is the Philippines, a market BAT deserted in 2009, despite the fact that 30% of adults smoke. At the time, BAT complained that the tax regime favored local brands and made BAT's imported cigarettes uncompetitive.

BAT has recently announced that it is going back into the Philippines. Coincidentally, the excise duty regime is currently being reviewed to provide a more even playing field.

Smoke, but no fire
I don't think the end is nigh for big tobacco -- quite the opposite. I feel confident that growth in Eastern Europe, the Middle East, Latin America and Asia will outweigh any shrinkage in North America and Western Europe for a long time to come.

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