Price war sees earnings go up in smoke

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’S this? Have the Spanish decided to kick the habit? A 16 per cent underlying decline in cigarette volumes during the first half certainly suggests so. The ban on smoking in public places, higher duties and a weak economy appear to have taken their toll. Now Imperial Tobacco has warned that a price war is likely to wipe £110m off its annual adjusted operating profits in Spain.

We suspect the black market is partly to blame. The illicit tobacco trade in Spain is rife, and probably accounts for a significant proportion of the recent decline in volumes. That means the tobacco companies have to compete not only against each other but also against the man selling contraband.

The Spaniards already enjoy cheaper fags than other Europeans. A pack of Marlboros sells for €2.00 less in Spain than the average price in the rest of the EU’s big five – France, Germany, Italy and the UK.

With four major players and a shrinking market, competition is fierce. Philip Morris recently cut the price of its L&M brand to €3.30 to compete with British American Tobacco’s (BAT) Pall Malls. That left Imperial’s largest label, Fortuna, looking expensive at €3.40, so it decided to cut prices too.

The weakness in Imperial’s shares provides a buying opportunity. Even after earnings per share forecasts were trimmed following yesterday’s announcement, the firm traded on price to earnings ratio of 9.6 times earnings forecasts for calendar year 2012, compared to 12.8 times for BAT.

Eventually, Spain will have to deal with contraband cigarettes, which are hitting its coffers as well as those of tobacco giants. Analysts at Matrix reckon Spain loses as much as €6bn in lost duty and VAT due to artificially low prices and the black market.