Global tobacco players face an increasingly adverse general regulatory landscape and the pace of regulation is set to intensify. S&P Global Ratings anticipates that regulatory risk for tobacco companies globally will remain high.

From an environmental, social, and governance (ESG) perspective, we consider that the tobacco sector has the highest social risk among the branded consumer products sector. Smoking has been scientifically proven to have adverse health effects, and it therefore has an overall negative impact on health care and social costs globally. The growing focus on ESG considerations, and the evolving investor base, puts a greater onus on all the major industry players to demonstrate their sustainability credentials. All the large global tobacco players are investing in diversifying their product portfolio into potentially new reduced-risk alternatives as a future source of growth.

While the industry has a good track of record of cash generation, the Top 5 rated players in the industry had combined debt of close to $140 billion at the end of 2020. Although revenue was less affected by the pandemic, we foresee reduced rating headroom because of i) increasing regulatory volatility; ii) the ongoing decline in combustible cigarette volumes; iii) elevated spending related to new products; iv) potential acquisitions; and v) ongoing shareholder returns, which continue to consume the lion's share of their cash flows.

Fast-Evolving Regulatory Landscape Presents Challenges

The tobacco industry, while no stranger to constant scrutiny, is set to face more intense and wide-ranging regulatory challenges, in our view. Manufacturers have contended with punitive regulatory and legal actions, as well as significant and continually rising excise taxes. Legislation has been wide ranging across different countries and amongst other things has included the introduction of plain packaging, starker health warnings on packs, restrictions on smoking in enclosed public places and the display of tobacco products in shops.

In April, the FDA announced its commitment to issue proposed product standards within the next year. These would ban menthol as a flavor in cigarettes and ban all characterizing flavors (including menthol) in cigars in the U.S. If implemented, we believe the proposals would take several years to become effective. After publishing a proposed rule within the next year, the agency will have to review and consider comments from tobacco manufacturers and various other stakeholders before preparing a final rule. Legal challenges are likely and could delay implementation further. In the U.S., we estimate that menthol cigarettes account for about 35% of the total market. The large rated tobacco companies most exposed to the U.S. market are British American Tobacco PLC (BAT), Altria Group Inc., and Imperial Brands PLC.

Moreover, the vaping category has recently come under scrutiny after a vaping crisis broke out in the U.S. in December 2019. One of the FDA's main objectives is to prevent vaping among nonsmoking young adults. For this reason, the FDA recently raised the legal age for vaping to 21 years from 18 and increased enforcement against unauthorized flavored vaping products, including fruit and mint flavor.

Restrictions on vaping products in the U.S. have already caused the vaping segment to contract significantly and hampered category growth. At the end of 2018, Altria purchased a 35% share of vaping manufacturer JUUL Labs (No.1 player in the U.S. vaping market) for a total consideration of US$12.8 billion. However, over time, its investment has been substantially written down, taking the fair value of its minority stake to less than US$2 billion. The impairments were partly triggered by reduced growth expectations and partly by the increase in the number and type of legal cases pending against JUUL.

The FDA had accepted about 6.9 million products for review under its Premarket Tobacco Product Application (PMTA) process, with an original deadline for review of Sept. 9, 2021. This process applies to any new tobacco products marketed in the U.S. and decides which of them can remain on the market. New products are defined as any tobacco products not commercially marketed in the U.S. as of Feb. 15, 2007. As a result of the PMTA process, the FDA has issued market denial orders on many small and midsize companies' vaping products, but has delayed its decision on the industry's largest players: JUUL, BAT's Vuse, and NJOY.

The U.S. is also considering a rule to reduce nicotine in combustible cigarettes to minimally addictive levels; we understand that this is not considered a priority. Although the financial impact of such a rule could be severe, we see it as a longer-tailed, lower-probability event.

The U.S. is not the only country to subject the industry to intense regulatory attention. The EU and the U.K. banned menthol cigarettes in May 2020. Discussions regarding the revision of European Tobacco Products and Tobacco Excise Directives are underway. They aim to cover topics such as taxation of new tobacco categories, regulation of flavors, and legislation of snus and other oral tobacco products, at a European level. However, we do not expect the European Commission to achieve a harmonized approach for excise taxation of new tobacco product categories across all EU countries in the short to medium term. The environment in the EU differs from country to country, with each applying taxes at different rates. In July 2021, Germany--one of the largest tobacco markets in Europe--passed a new law (the Tobacco Tax Modernization Act) to raise excise taxes on heated tobacco and vaping products. From January 2022, cigarettes, water pipe tobacco, and heat-not-burn products will be taxed at higher rates. In addition, from July 2022, vaping products will also be subject to tobacco taxation, even if they do not contain any nicotine.

Regulatory risks are also common in emerging markets. For instance, in South Africa, the government imposed a ban on all tobacco sales from late March 2020 to August 2020. In Indonesia (the second-biggest global market after China, by volume), the government significantly increased tobacco excises at the beginning of the year.

We expect to see more policy and regulatory shifts in several markets as the regulatory environment evolves toward reducing the harm caused by tobacco. Large tobacco companies have responded to the risk of more severe regulatory actions and accelerating volume declines in the core combustibles tobacco business by strategically investing in new reduced-risk and growth-oriented products. Although all the tobacco companies we rate have a good record of managing litigation and regulatory risk, we anticipate that the operating landscape will only become more difficult amid greater regulatory scrutiny, suggesting a higher risk of regulatory sanctions, fines, and penalties.

Combustible Cigarette Sales Backstop Profitability, Despite Shrinking Volumes

Demand for combustible cigarettes is likely to continue its secular decline as consumers become more health conscious. As the quality of noncombustible alternative tobacco products improves, they are gaining in popularity. Euromonitor forecasts that cigarettes volumes will drop by 1.5% in 2021, from 5.2 trillion sticks in 2020, and that global cigarette volumes will fall below 5 trillion sticks in 2023.

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Although combustible cigarette consumption volumes are declining, we expect large companies to sustain their strong profitability by raising prices to offset the volume declines. Combustible cigarettes still account for 85% of the industry's global revenue and this share is unlikely to decline much in the near term. Euromonitor expects the size of the cigarette market alone, in value terms, to increase each year over the next five years, reaching US$850 billion in 2025 from US$717 billion at the end of 2020. Even as volumes shrink, and despite the sharp growth in reduced-risk products (RRPs), we expect combustible cigarettes will represent 78% of revenue in 2025 and remain the main contributor to the industry's profitability for at least the next few years.

More importantly, the main tobacco companies rely on sustained strong profits from their combustibles portfolio to fund investments in alternative products in the coming years.

Alternative Nicotine Products: Huge Investments, Only Modest Profit Contribution

Global companies are investing in next-generation products (NGPs) to differentiate their products as innovative and so gain a competitive advantage. According to Euromonitor, in 2020, NGPs (vaping, heated tobacco, and modern oral) accounted for about 7% of world tobacco retail value (excluding China), while for North America its contribution was close to 16% of overall industry (see chart 2 below).

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Investing in NGPs could also be important in mitigating the tobacco industry's exposure to ESG risks, especially if claims of their reduced-risk product features are fully proven and widely accepted by consumers and regulators. At present, only IQOS--Philip Morris International Inc.'s (PMI) heated tobacco product--and some Swedish Match snus smokeless tobacco products have obtained authorization from the FDA to be marketed as modified-risk tobacco products (MRTP). The MRTP classification indicates reduced exposure to harmful chemicals compared with conventional cigarettes. As a result of this authorization, we believe that heated tobacco and snus could gain a competitive advantage over other new tobacco categories.

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IQOS is a clear market leader in the heated tobacco segment. At year-end 2020, IQOS reported about $6.8 billion in net sales; nearly 24% of PMI's net annual sales (up from a 2.7% contribution in 2016). According to the company, IQOS reached about 18 million users, of whom more than 70% are estimated to have switched to IQOS and stopped smoking traditional cigarettes. According to Euromonitor, IQOS has about 65% of the global heated tobacco (device) market, with Ploom by Japan Tobacco Inc. (JT) and Glo by BAT, having market shares of about 12% each. The commercialization of IQOS in U.S. has recently been hit by a patent infringement case filed by R.J. Reynolds (BAT Group). The International Trade Commission (ITC) therefore ordered Altria and PMI to halt the import and sales of IQOS products and the case will now move to an administrative review. The import and sale ban will take effect in about two months, and we expect PMI and Altria to appeal the ITC's decision.

In our view, because of NGPs' role in protecting and improving competitiveness, companies that lag behind may see reduced long-term growth prospects. Accordingly, we expect tobacco companies to ramp up investments in new technology and product development focused on alternative nicotine-delivery products.

The product categories that are increasing their relative contribution in the NGP value share are heated tobacco products, which has about 37% of global NGP value and nicotine pouches (2% of NGP value). We note that nicotine pouches are a very niche segment that focuses on just a few markets, such as the U.S. and Scandinavia.

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Many tobacco companies have expressed their desire to encourage smokers to use noncombustible products in future. They are accelerating investments in alternatives, such as heat-not-burn cigarettes and oral nicotine pouches. Although we predict that investment will cause strong growth in these categories over the next few years, volumes remain very small, and their long-term success remains uncertain. Accordingly, we do not expect material near-term profit contributions.

PMI has had strong success with IQOS in its markets and progressing its goal of transitioning smokers away from combustible cigarettes. Both BAT and JT have positioned reduced-risk products as a future source of growth and are investing heavily in this segment. Although they are seeing strong growth in their Glo and Ploom brands--Glo leads Ploom in the heated tobacco sticks market, by volume share--they both lag substantially behind PMI in this fast-growing segment. That said, we see both these companies investing significantly in the heated tobacco segment and launching new and more price-competitive products in an attempt to increase their revenue from this category and bridge the gap with PMI.

High Shareholder Remuneration With Elevated Investment In New Products Diminish Rating Headroom

In our view, large tobacco companies need to create a financial buffer on their balance sheets to combat regulatory challenges and build headroom under our ratings. This could constrain their choices in terms of allocation of capital and shareholder returns, if they aim to maintain current ratings. Strong cash flow generation at these companies has supported their credit quality and ameliorated concerns about secular volume decline in combustibles and the costs (operating and capital expenditure) associated with launching new products. Our current rating outlook on the sector is stable and only one company (JT) has been downgraded in the past year.

Although cash generation remains very strong, most of the main players adopt a shareholder-friendly remuneration policy, which consumes most, if not all, of their free cash flow. The companies offer high and regular dividend payouts and, in many cases, significant share buybacks.

We expect to see ongoing portfolio adjustments through bolt-on merger and acquisitions (M&A) and disposals activity in the sector. These acquisitions highlight large tobacco companies' desire to diversify their product offering by acquiring expertise and innovative technology from other industries. For instance, PMI's acquisition of Vectura (a U.K.-based pharmaceutical company with a focus on inhaled drug delivery solutions) followed its earlier acquisition of Fertin Pharma (a Denmark-based manufacturer of nicotine gums, pouches, and other solid oral systems for the delivery of active ingredients). Both are targeted to accelerate its "Beyond Nicotine" strategy. Moreover, BAT has decided to strengthen its oral products through the acquisition of certain assets of Dryft (a U.S.-based modern oral company). The transaction completed in the last quarter of 2020.

Altria also aims to capitalize on potential long-term growth in the cannabis industry. It owns 42.1% of Cronos, a global, vertically integrated cannabis player which has grown rapidly, and has an estimated $1.3 billion warrant to increase its ownership to 52.1%.

Conversely, disposal transactions may be used as part of overall portfolio optimization and to reduce debt. In 2020, based on its commitment to achieving a target leverage ratio at the low end of the 2.5x-2.0x range, Imperial Brands completed the disposal of its premium cigar business for a total consideration of about €1.2 billion. More recently, Swedish Match announced the planned separation of its cigar business via a spin-off to shareholders. The separation is expected to be completed during the second half of 2022.

In the past, the industry has seen large consolidation. BAT acquired Reynolds American Inc. in 2017, making it the largest listed tobacco company globally. JT has been most frequently acquisitive in the peer group. The series of large acquisitions it made between 2016 and 2018 caused its financial position to weaken.

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It is unlikely that JT's financial standing will recover swiftly as it continues to invest heavily in reduced-risk products to regain its competitiveness in its domestic tobacco business. Although we recently lowered our rating on JT by one notch to 'A+', it remains the highest rated company, with the lowest leverage in its peer group.

BAT has also been slow to reduce its leverage; we consider BAT (BBB+/Stable/A-2) has very limited headroom at the current rating level, should there be any negative deviation to our base case. Our downside scenario mainly relates to BAT's financial policy decisions around offering more favorable shareholder distributions, a slowdown in the penetration of new products, or existing litigation potentially weighing on the company's financial metrics.

Sustainability Will Play An Ever More Vital Role in Driving Investment Allocation

Tobacco company bonds often trade at a wider spread than similarly rated corporates. Furthermore, tobacco spreads often show large volatility when there are announcements about regulatory reviews, taxes, or litigation. For example, when the news that the Biden administration would be exploring a ban on menthol cigarettes and a policy to reduce nicotine levels in cigarettes dropped earlier this year, we saw strong market reactions and widening of the large tobacco companies' bond spreads. We expect continued volatility in spreads and regulatory risk to weigh on the sector going forward. The chart below suggests there is a potential risk premium in the Euro market due to higher weighting of sustainability considerations by investors in the European market. That said, we cannot be definitive as many factors influence bond pricing and it is difficult to isolate specific ESG- or industry-related factors. A similar analysis for U.S. dollar-denominated bonds would suggest that little or no additional risk premium exists for tobacco companies.

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Most of the large, rated companies in the sector have retained a strong liquidity profile, underpinned by good access to capital markets, strong relationships with several banks and financial institutions, and substantial committed lines of credit. Based on S&P Global Ratings' annual adjusted numbers, average interest costs for the large players reduced in 2020, compared with the previous year, to 3.5% and the companies maintain comfortable interest cover based on strong EBITDA margins.

Companies such as JT and BAT are steadily diversifying their funding sources and expanding their investor base by raising hybrid financing. The quasi-equity-like nature, IFRS equity accounting classification, and the intermediate treatment of these hybrid instruments under our adjusted debt calculations in many cases, could also lend moderate benefit to the credit metrics. JT issued over ¥200 billion of hybrids in Japan and overseas in 2020. BAT has also recently issued two perpetual subordinated hybrid instruments with an aggregate amount of €2 billion to diversify its funding base and reduce reliance on longer-dated, U.S.-denominated senior debt.

Investors across equities, fixed income, and other asset classes are integrating sustainability into their investment decisions and oversight of portfolios. The EU's Sustainable Finance Disclosure Regulation (SFDR), which seeks to enhance sustainability-related disclosures by imposing requirements on financial market participants, has already had an impact on certain large investment funds' allocation to the tobacco industry. The regulation is part of the European Commission's Action Plan on Sustainable Finance and its Level I requirements came into effect in March 2021. The implementation of its other standards is planned for 2022 and 2023.

Although some prominent funds have begun to apply sector exclusion policies to the tobacco companies, based on their view of the social risks, the sector's ability to successfully navigate regulation risk and its strong cash generation characteristics will continue to hold great appeal for certain types of investor. That said, we do not rule out a higher mix of specialist financial investors, including hedge funds, forming a greater proportion of the investor base going forward.

Tobacco companies are also aiming to integrate their financing more closely with sustainability goals. For example, PMI published its Business Transformation-Linked Financing Framework, under which issuances under the framework will include a margin step-up, adjustment, or premium/discount that is subject to the achievement of certain ESG targets. The framework's two targets are to improve full-year net revenue (based on U.S. generally accepted accounting principles) from the company's smoke-free products to more than 50% of total net revenue (from 23.8% in 2020); and to make these products available in 100 markets by end-2025, up from 64 at the end of 2020. PMI has recently entered into a new five-year revolving credit facility under this framework, for borrowings up to US$2.5 billion.

We anticipate that investors will continue to scrutinize and tailor their investment approach to the tobacco sector, with a view to integrating sustainability principles into their investments. For now, the large tobacco companies remain well invested, with a diverse investor base across the capital structure. The sustainability factor has not made a material difference to investors' current interest in the sector, but it could affect cost and access to capital over the medium term. In our view, the sector's large, rated companies are unlikely to see a near-term meaningful effect on their funding ability, mix, or cost and access to capital.

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Related Research

• Second Party Opinion: Philip Morris International's Business Transformation Linked Financing Framework, Aug. 27, 2021
• U.S. Menthol Ban Will Test Tobacco Companies' Preparedness For Future Restrictions, May 5, 2021