Profits are set to plunge in the European Tobacco Industry as cigarette-makers struggle against the long-term decline in sales volumes.

The prediction is from rating agency Moody’s, which has issued a new report on the European Tobacco industry detailing some of the forces working against the sector.

Moody’s has downgraded its industry-wide operating profit growth expectations to around 2.5%-3.5% (not including currency impacts) from the 4.5%-5.5% it expected in “late 2013/14”.

The tobacco stocks have been some of the most reliable companies on the market during the recession – with the share prices of British American Tobacco and Imperial Tobacco growing by 70% and 42% respectively over the past five years. However, in recent month the evidence is mounting that changing market conditions are beginning to catch up with the cigarette firms.

“We expect that demand in the European tobacco industry will continue to fall in developed markets and this is the biggest pressure on operating profit”, Lola Cavanilles, Moody’s analyst, explained. “Sluggish economic growth and subdued consumer confidence have resulted in a trading down to cheaper brands, while tighter regulation and growing awareness of the effects of smoking on health mean fewer consumers are taking up the habit”.

While these pressures aren’t new, they’ve now been joined by the damaging effect of currency movements and a slowdown of growth in emerging markets to curtail the tobacco firm’s growth.

In August, Imperial reported a 1% fall in global revenue for the first nine months of the year, blaming the political situations in Russia and Iraq weaker emerging markets revenues and warning that the strength of the pound could impact full-year operating profits by 5% if exchange rates remained similar to current levels.

Then last week BAT reported a 9.6% fall in headline revenues during the nine months to 30 September, and a dip in global cigarette volumes of 1% to 495 billion as sales volumes fell in Russia and Brazil.

Moody’s notes that developing market volumes will continue to rise, but price increases will still lag and there is also rising longer-term risk of tighter regulation in developing markets, which could slow demand growth.

Additionally, the much trumpeted growth of the e-cigarette is unlikely to help the bottom line. Moody’s notes that, despite global e-cigarette consumption will increase faster in developed markets than for other tobacco products, the early stage of the market development would mean such products will not “move from loss-making/breakeven to meaningful profit contributors in the next 12-18 months”.

Moody’s also poured cold water on speculation that BAT could line up a move for Imperial Tobacco – arguing it “does not anticipate a merger of any of the big tobacco companies in Europe, although this does not preclude small bolt-on acquisitions of local independent players”.

Surprisingly the gloomy market predictions – and less than stellar recent trading updates – have not hit the share prices of the UK-listed tobacco firms too significantly (BAT’s 3.4% drop over the past month is tiny compared to some of its grocery/fmcg sector contemporaries).

A key reason for the solid share prices is their history of good dividend per share payments and earnings growth. That growth is now coming under sustained pressure.

Last week broker Jefferies trimmed its full-year 2014 EPS forecasts by 2% (from a low-end view) and FY15 by 3% to “reflect a weaker top line and less margin progress as the result of weaker-than-anticipated pricing”.  

However, Jefferies new forecast still equates to 7.5% EPS growth in FY14 (at a constant currency basis).

Times might be getting tougher for the cigarette firms, but both BAT and IMT currently have more ‘buy’ than ‘sell’ recommendations, suggesting the brokers believe they can continue to tread the tightrope of rising profits or falling volumes for some time yet.

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