Price hikes and cost cuts light stable fire for Big Tobacco

Solid price increases, a stronger product mix and successful cost-cutting measures will drive steady operating profit growth and keep the overall outlook for European tobacco companies stable over the next 12-18 months, according to Moody's.

In a recent note to its clients, the ratings agency said the companies' leverage ratios will improve marginally on the back of steady earnings growth, the neutral foreign exchange environment and the contribution of more profitable US acquired assets in the case of British American Tobacco (BAT) and Imperial Brands.

However, high dividends will constrain free cash-flow and there is limited capacity for large debt-funded mergers and acquisitions without eroding credit quality, Moody's added.

Philip Morris International (rated as 'A2 stable' by Moody's) will benefit from both dollar weakness, as it reports in dollars, and currency stability in emerging markets where it generates around 50% of its operating income.

Concurrently, the pound's weakness will favour British American Tobacco (Baa2 stable) and Imperial Brands (Baa3 stable) as the majority of their profits come from outside the UK. However, the weaker dollar will hurt Swedish Match's (Baa2 stable) earnings as 37% of its sales come from the US.

Ernesto Bisagno, vice president and senior credit officer at Moody's, said: "Price hikes combined with stronger product mix and cost cuts will help European tobacco companies grow operating profits at 5.0%-6.0% over the next 12-18 months, offsetting the expected 2.0%-3.0% drop in cigarette sales volumes as smoker numbers fall and underpinning the stable outlook on the sector."

Cigarette consumption continues to increase in the Middle East and Africa, but is declining in Russia, most Eastern European countries and South America. "However, price increases should more than offset lower volumes," the agency concluded.