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Top tobacco industry stock analyst says the pivot to tobacco harm reduction products is real and could potentially replace traditional combustible cigarette revenue entirely.

Featuring: Jonathan Fell
Tobacco Industry Analyst
Fmr. Partner & Co-founder, Ash Park Capital


Brent: Hi, I'm Brent Stafford and welcome to another edition of Reg Watch on GFN TV. Is big tobacco a threat to the nicotine vaping industry? For many vaping advocates, it's an old and touchy question. Most assume that at some point to tobacco companies acted to thwart vaping's rides. Yet today big tobacco is positioned to drive the future of vaping. The question: is there room for both? Joining us today is someone uniquely capable of answering that question, Jonathan Fell. For over 30 years he's covered the tobacco industry in his role as a financial analyst for tobacco stocks. Jonathan, thanks for coming on the show.

Jonathan: Thank you very much for having me, Brent.

Brent: It's great to see you. Before we begin, a quick note to our viewers here on GFN TV. Today's episode is part of our two part interview with Jonathan Fell. Part two is scheduled for release on our main Reg Watch social media channels on in just a few days. Jonathan, you've watched vaping's rise across the globe over the past decade. How fast was it and why has it proven to be so popular?

Jonathan: So, from my perspective, as someone who's watched the tobacco industry for nearly 30 years, we've seen a pretty rapid takeup in vaping and it was something that very quickly caught the imagination of the financial community who wanted to know what impact it would have on the industry. And it took a while for the companies to react. But I think as we'll touch on much later in more detail, a lot of the big companies are now very heavily involved in vaping and it's not going to go away. And what's driven that really is the consumer. And the consumer is always at the heart of this story. And I think the rapid grassroots adoption of vaping as something that a lot of people who smoke cigarettes switch to has made this a very important phenomenon.

Brent: Jonathan, please take a moment to fill our audience in about your background and experience in this area.

Jonathan: So I started my career as an equity analyst, writing about companies for investment clients at various investment banks in London. And I got given actually the tobacco sector to follow because it was a little niche that more senior people didn't want to cover. But I found it really interesting. I mean this was the early mid-nineties at a time when the industry was under a lot of pressure from litigation and regulation. It was public enemy number one in a lot of senses. And so that fascinated me. And I've watched a story with a lot of interests, you know, ever since then, and how the debate has evolved and it really has evolved in some interesting ways.

Brent: Now, in your last position that you had at Ashpark Capital, you were actually involved in actually the investments in tobacco companies, is that not correct?

Jonathan: That's right. So about ten years ago I switched roles a bit, moved to the other side of the fence. So instead of advising people on how to invest, we started to do it ourselves. So I set up Ash Park with some friends to invest in consumer stocks, and quite a big part of our portfolio was tobacco. So you're right, I have invested in tobacco stocks as a fund manager as well.

Brent: And how big could those positions grow to?

Jonathan: We were a niche fund manager, so we had several hundred million dollars under asset management at our peak, but I mean, tobacco was up to a quarter of that. So they were sizable positions, certainly in tobacco from the point of view of our funds.

Brent: So take us back to the 1990s. Is it fair to say, and I think you alluded to it whether or not Big Tobacco was on the run?

Jonathan: Yeah, it was. I mean, you had the congressional hearings in the early ninety s. You had all these class action lawsuits, you had people starting to win individual cases in the US. Against tobacco companies for the first time, and you had the dynamic that eventually led to the Master Settlement agreement. And through that period, especially in the early days, people genuinely did fear that Mitigation could be the death of the tobacco industry as we knew it then, but it could put these companies out of business.

Brent: Did Big Tobacco behave badly? Because clearly public health has had it out for big Tobacco for decades now.

Jonathan: I think the US. Tobacco industry, which is what people generally perceive to be Big Tobacco, did behave badly. Yes, I think they were not upfront about what they knew about the risks, and I don't have a lot of sympathy for them in terms of the way they are now perceived. I think though, that maybe the industry overall, and I'm going beyond the US. Now to talk about how the industry developed elsewhere in Europe, in Japan, even Eastern Europe, Asia, where it was state owned in many cases, that pattern of behavior you saw in the US. Didn't necessarily get replicated elsewhere. And so I think it's a problem for the global tobacco industry now that the perception of what the US. Companies did has come to color the whole debate about what the companies do now.

Brent: Has that also, in retrospect, also colored people's perception of vaping?

Jonathan: I think it certainly colored people's perception of vaping because there's a kind of knee jerk reaction now that people have when they think about what the tobacco industry does, which is that everything they do has to be bad. And I think a lot of that backstory on tobacco has given vaping a bad name because some people, for understandable reasons, think, well, they're just trying their same old tricks again, they're trying to hook another generation on nicotine, all those cliches that we're used to hearing. And that's a problem for the companies. It's also, unfortunately much more unfortunately a problem for tobacco harm reduction overall. It's that it seemed to be tainted by what the tobacco industry involvement is.

Brent: Now, let me ask you, didn't big tobacco back in the late 90s, early 2000s, attempt to make a safer cigarette? So didn't they kind of try to lead the way in tobacco home reduction?

Jonathan: Yes, I mean, not surprisingly, once it was figured out that cigarettes were bad for health, the companies did make efforts to make those cigarettes less dangerous. But for reasons you'll understand, it's pretty much impossible to make anything that's combusting tobacco, combusting an organic product safe. So for a long time, those efforts were not very fruitful. And I suppose by the time we get to the late 80s, early 90s, we did have something which could be the core of what might go on to be a useful product later on, ie. Tobacco heating rather than burning with the eclipse and premiere product from reynolds. But it took a long time, and it wasn't really until the 2000s that more viable, reduced harm products started to be sold in earnest by the tobacco companies and starting from smokeless tobacco moving into tobacco heating and obviously vaping now as well.

Brent: Jonathan, one of the things that interests me in this conversation is the fact that I know, certainly I have, and many vaping advocates do think that vaping products are a consumer packaged good and they should thus be regulated as such. Instead, they've been regulated as a deadly tobacco product. As somebody who understands CPG well, what do you think?

Jonathan: I think you're right, and I think this is a really critical part of the debate, which is not well understood. So the way this is typically framed is that you've got a bunch of companies selling a deadly, evil product on the one hand, and to caricature things, a bunch of addicted people who can't help themselves and are killing themselves by having to smoke cigarettes because they can't give those up. And so the intervention that people normally think or have tended to think needs to be applied is to give those poor addicted smokers some kind of medicine, some kind of treatment to help them quit the habit. And I can see why that situation has arisen, but I think it has tended to be a very poor solution to dealing with the problem. And we've seen over the years that nicotine replacement therapies have not been very successful. And I think that's because they tend to not really address many of the reasons why people actually smoke. And I think it's a very complex habit, a very complex phenomenon, smoking. But I think in my experience, the vast majority of people who smoke don't really regard themselves as people needing treatment. Some of them might. Some of them regard themselves as using cigarettes like most other consumer products. And if you really want to get them to step away from cigarettes, you've got to offer them a substitute consumer product. These people don't want to be treated. They want to feel good about themselves. Many of them, I think, enjoy using nicotine. And that's to me, why vaping and the other tobacco harm reduction products are really interesting, because they're giving something to people who use cigarettes, people who use nicotine that empowers those people rather than kind of patronizing them.

Brent: Isn't that compulsion that need to consume the cigarette as a product? Isn't that addiction to nicotine what actually drives the business for tobacco?

Jonathan: Yes. At roots, if you're a tobacco company, you are making money out of selling products that people feel a compulsion to keep using. Now, I think tobacco is probably at an extreme edge of a continuum there, but it is a continuum. So there are lots of other things that companies sell people and which people willingly buy that people also feel at least some kind of compulsion or habit that they want to keep on using. It be that alcohol, soft drinks, food, beauty products. In the end, most consumer product businesses work around selling people things that they hope those people will come back and keep purchasing.

Brent: Jonathan, let me ask you, is there a war on vaping, and is it the same as the war on smoking?

Jonathan: I think there is a war on vaping. I don't think it's exactly the same as the war on smoking, but I think it has some of the same root causes to address that. I think that a large part of the way this debate, again has been framed over the years is that you've got a baddie, the tobacco industry selling products to victims, smokers. For a lot of people on the public health side of things, tackling the smoking problem has been synonymous with tackling the tobacco industry. And let's face it, until tobacco harm reduction products started to be available more meaningfully to consumers, it wasn't really worthwhile necessarily drawing much of a distinction between those things. But now we have a situation where tobacco companies are able to offer consumers something that's a lot less risky than a lot less harmful than cigarettes. And so that old certainty that if you just bashed the tobacco industry, you were going to do something that helped address the smoking problem has gone away. But I don't think everyone has bought into that story yet. Not everyone agrees with that. And that is why I think vaping has become one of the reasons why vaping has become such a contentious issue is that it is seen in some quarters as a way for the tobacco industry to somehow perpetuate the damage it's done. And some people are unwilling to believe the idea that vaping might be actually a lot less harmful.

Brent: And does it not also connect with, if you believe, let's say, your public health tobacco controller and you believe that it is possible to annihilate the tobacco industry and bring it to its knees and have it gone, then the kinds of thought is that these vaping companies are like a last breath. They're a lifeline for tobacco. And so they're kind of spinning on that issue.

Jonathan: I think that's right. But to me, it's a misconception that if you put the big tobacco companies out of business tomorrow, would smoking go away? I mean, almost certainly not. People would find a way to get hold of products that be in massive black markets. Look at cannabis. Up until very recently, in North America at least, cannabis had been illegal. But there's enormous numbers of people who use those products, and I think it would be the same in tobacco. If you got rid of tobacco companies, you wouldn't get rid of smoking.

Brent: Jonathan, with all the panic around smoking, how do you make the argument to invest in tobacco stocks?

Jonathan: There is panic about smoking, rightfully, because it's a very dangerous habit. But people worked that out nearly 70 years ago now, and it's at least for 50 years that in most developed markets around the world, smoking prevalence has been declining. So tobacco companies have been used to dealing with declining volumes of their major products for a long time, and they've got a lot of pricing power which has helped offset that. Tobacco companies produce still a lot of cash flow, and there's not a lot of things for them to be spending that money on. So those cash flows tend to find themselves paid back to shareholders either through dividends or through the companies repurchasing their own stock. The trade off of the value of those cash flows versus also the low valuation on which these stocks tend to trade versus other similar consumer companies, because people are worried about that long term volume decline. That's tended actually to produce rather good returns for investors. And although we've had a tough five, six years for the industry overall and a lot of derating actually, of these stocks, that the long term record of returns for investors from these companies is actually quite good.

Brent: So what are the hurdles then to overcome when you're talking with investors?

Jonathan: People on the investment side are still worried that eventually we'll reach a day when there's so few smokers that you won't be able to offset declining volumes by putting pricing up. So people are concerned about the legacy business running into the sand at some point, and they're also concerned that maybe vaping or tobacco heating or tobacco or whatever won't grow enough to offset the loss of those businesses, of the traditional combustible businesses. So those are the concerns about the business model. And then you have concerns that maybe tobacco is just something I, as an individual or as a business who hopes to be having responsibly, shouldn't be in investing in at all. And I'm sure you're aware about the rise of ESG investing, investing that takes account of environmental, social, and governance factors. And we're still, in the very early days, I think, of people working out how to do ESG investing effectively. But one of the broad brush approaches that people have tended to take, who have taken that investing approach is just to refuse to touch anything that they think is really bad. And tobacco has often fallen into that bucket. And that's one of the reasons why tobacco stocks, I think, have been pressurized over the last five or so years. But I do think that ESG investing is we're still in the early innings of working out how ESG investing can really do good for the world and I think as we get more sophisticated in that, people will start to think that a pure divestment approach, ie. Just refusing to own anything we think is controversial, actually doesn't necessarily achieve that much good and maybe you're better taking the difficult step of actually having a stake in these things. After all, it's a society problem and that problem doesn't go away just because you won't touch it. So let's have a stake in these things, let's engage with the companies, engage with managements and try and push them in a more responsible direction and that's the approach that to me makes more sense and has more chance of getting stuff done in the long run.

Brent: Could they not just take these tobacco companies private?

Jonathan: Well, I think if you take divestment to its logical extreme, these companies going private, it is exactly what would happen because there'd be one or two people still out there who would be prepared to snap up these companies and they get them at a bargain price. And if you think through the implications of that, they're not necessarily very helpful in that being a public company does bring with it a lot of reporting requirements and it brings with it engagement requirements as well. You are forced to talk to your shareholders and you're forced to publish annual reports and you are held accountable at AGMs and other meetings. Private businesses are very much less accountable and I think that would be a negative thing for the public health overall if all the large tobacco companies were much less accountable than they are now.

Brent: Is part of the move to reduce risk products intended to placate some of the ESG issues and to shore up the investments?

Jonathan: I think if tobacco companies get involved in tobacco harm reduction products, certainly there's a benefit to them on the PR side of being seen to be more responsible, doing the right thing, et cetera. But I think it can't purely just be about that and it isn't. For a start, I think if people saw that it was just talk and not underlined by real investment, real actions and real progress in terms of these products accounting for a larger portion of revenues than it would be seen through very quickly. And tobacco companies aren't stupid. They know what their reputation is, they know about their history. And they are, I think, mostly very keen to avoid the mistakes of the past. So, yes, it has a PR benefit, but every company I know, of the large ones in tobacco, is very serious about engaging with tobacco harm reduction and trying to grow that as a percentage of their business.

Brent: So tell us about that, Jonathan, who are the big players and what are they doing?

Jonathan: So you've got really four or five large companies that people tend to think of as Big Tobacco. You've got Philip Morris International. You've got British American Tobacco and you've got Japan tobacco. I mean, those are the three really global players. Then in the US, you've got Altria, which used to be part of Philip Morris, but spun PMI out about 15 years ago. And then you have Imperial Brands, which is one of the sort of mid tier international companies listed in the UK. So those are the large international businesses. They're all quoted and they're all engaged in tobacco harm reduction in a different way. And I think this is one of the things that people sometimes fail to take into account as well, is this isn't a monolith all doing the same things, they've all got their different strategies and are all at different points on the journey. And the one that's furthest down it is Philip Morris, international PMI. They're the ones who have made the strongest commitment to transform their business and commit to a smoke free future. In the first nine months of 2022, 30% of their revenues came from non combustible products. And you might know that they've just gone and bought Swedish Match as well, which is one of the leaders in all tobacco in Snus and Snuff. So that's going to really cement their position as the as the leader. In fact, BAT is probably the next behind. They're at about 15% of their revenue now coming from THR noncombustible products. And then you've got to my mind anyway, JT, Japan Tobacco, Imperial and Altria some way down the line, but they're all making moves to try and increase non combustible products as a proportion of their revenues and those efforts are really very serious.

Brent: And that brings me to my next question is can they be taken seriously, those commitments?

Jonathan: I think people should always be skeptical about any claims that public companies make, whether it's tobacco or something else to be improving and doing the right thing. But what do you have to do is judge them by results. And the great thing about, again, these things being public companies is they have to publish annual reports and you can see what progress they're making. And they all report now the level of revenues and volumes that do come from reduced harm products. And on top of that you've got third parties. And in particular, I'd highlight the Tobacco Transformation Index, which is organized by the foundation for a Smoke Free World, which is measuring that progress as a third party as well and trying to hold these companies to account. By all means, people should be skeptical, and they should give these companies a hard tie if they like for not moving fast enough. But I think nearly all of them, you can see some progress.

Brent: Now are these moves that tobacco companies are making in the reduced risk products THR, we always say, and you've been referring to tobacco harm reduction. Do investors understand tobacco harm reduction and are they rewarding big tobacco companies for their efforts?

Jonathan: I think investors are very focused on tobacco harm reduction and on the impact it has on these businesses. And I would say the most important thing they look at is, is this a thing which can replace the legacy combustible business? If smoking prevalence is going to keep on declining, if we're going to get prohibition at some point in various markets like New Zealand, can tobacco harm reduction replace those cash flows that would be lost from cigarettes? I think people understand that on the investment side. And I think people also are on the investment side, also convinced of the public health benefits of reduced harm products. I mean, they really do regard trying to get people who smoke to switch to vaping or tobacco heating or to oral tobacco as a no brainer. They are convinced by that scientific evidence. I think where they struggle a bit is in realizing how difficult that transition is and not understanding completely what the barriers are. So if to you it's really obvious that switching people to vaping is a good thing for public health, then why on earth are people standing in its way? And I think that's the regulatory side and the debates within public health and the challenges that some in public health put in the way of tobacco companies trying to transform is not necessarily something that's widely understood. People are aware of it to some extent, but I think it's difficult to understand because of that perception people have that it's kind of a no brainer that you'd want people to move in that direction.

Brent: Now you alluded to something there I think it's pretty important to dive more deeply into, and that is whether or not safer nicotine products can deliver the same kind of revenues to big tobacco as, say, combustibles do, because of course, cigarettes make a lot of money. Can vaping actually replace that?

Jonathan: My view is that very much tobacco harm reduction products can replace the revenues from cigarettes. It's a more complex picture. I mean, traditional cigarettes are incredibly profitable things. They're one of the most profitable consumer goods you can sell. Across the different THR products, you have a range of levels of profitability at the moment, and generally, the closer those products are to traditional tobacco, the more profitable they are at the moment. So Snus and moist snuff have margin levels very similar to cigarettes. So the nicotine pouches and tobacco heating, I would say, is pretty rapidly reaching cigarette kind of levels. A lot of the reasons for that is because it's only tobacco companies who want to get involved in those product areas. They don't want to bring on the regulatory and litigation burden and reputation burdens that being associated with tobacco is seen as bringing. Once you get into vaping, you've got, as you know, a much wider field of companies and businesses being prepared to get involved so it's more competitive. And so I think if you were to look at the vaping lines of major tobacco companies, they're not yet anything like as profitable as cigarettes are, but that doesn't mean that you can't make good money out of them in the long run. We know that there are plenty of profitable vaping businesses out there. And an important thing to realize is it's one thing making a lot of money in cigarettes, but if that business doesn't exist in five to ten years time, then it's got a limited value in the eyes of investors. Vaping could have maybe only ever has margins which are a quarter of what cigarettes has. I think it'll probably be higher than that. But if they had margins which were a quarter of cigarettes, but that was a business which was going to be around for the next 50, 60 years, that would still be a very valuable business in the eyes of investors because it's sustainable in a way that combustible products are not.

Brent: Jonathan, over the past two years you've participated in two great presentations at the Global Forum on Nicotine in Warsaw, Poland. And of course, it's coming up again this June from June 21 to 24th. Jonathan, why is an event like GFN important?

Jonathan: I love GFN. I think it's a brilliant event. And the main reason I like it so much is that it has consumers at the center. And it seems really weird. But incredibly, not many of these kind of events have involved the consumer over the years. And consumers have very often generally been ignored. In a lot of the way this debate has been carried on, which I just find absurd, it's public health and the tobacco industry shouting over the heads of consumers and quite often not bothering to ask them what they really think. If society's issue with smoking is to be addressed, then the consumer has to play a really central role in that. And I think once you start getting consumers involved in the debate, both the industry and public health, people start to have to look at things in a different way. So I think their presence is really vital. It's stimulating, and apart from anything else, they're great people, really fun people to hang out with.

Brent: That's awesome. Thank you, Jonathan. And I'd like to remind the audience to keep watch for part two of this interview to be posted on regulator watch channels in the next few days. Last question for you, jonathan. Can big tobacco and independent vaping succeed playing in the same sandbox?

Jonathan: I hope so. I hope they can I hope that the regulatory environment around the world develops in a way which leaves room for the smaller guys. I am worried, looking at the US. That the way the FDA is approaching things, requiring such massive investment in scientific studies and consultants just to get products approved, that you will actually just price out a lot of the smaller guys from even getting their products on the market. I think that would be a really sad thing. We need all the innovation, all the investment in the category in the products that we can get. And the wider you can leave the playing field open to a broad range of companies, the more likely we are to have in 10, 20, 30 years time a bunch of products on the market which are satisfying enough that smoking has become a habit that only a very small number of people engage with.