Recent tobacco company results highlight the shift towards Next Generation Products (NGPs), Fitch Ratings says. This shift will help cushion the industry from weaker organic revenue growth from cigarettes, but will increase risk and uncertainty as cash flow generation becomes less predictable.

British American Tobacco plc. (BAT; BBB/Stable) said on Thursday that it expected NGP-generated revenue to double this year to GBP1 billion (almost 5% of 2017 BAT revenues), and to increase to more than GBP5 billion in 2022. BAT and Reynolds American, which it acquired in July, have invested approximately USD2.5 billion in NGPs since 2012, the company said.

BAT and, more recently, Imperial Brands PLC (BBB/Stable) have both adjusted their strategies to complement tobacco products with various NGPs. BAT is focusing on both e-vapour and heat-not-burn technology. Imperial is planning to launch several new products in 2018, leveraging on its “blu” e-vapour platform and testing heat-not-burn.

Philip Morris International, Inc. (PMI; A/Negative) benefits from first-mover advantage in heat-not-burn, which may enjoy high consumer acceptance as the NGP that most closely resembles cigarette smoking. Its sales of HeatSticks and of IQOS devices grew to USD3.6 billion in 2017, of which Asia accounted for USD3.2 billion, up from USD0.7 billion in 2016, according to the company’s most recent results. NGPs represented almost 13% of PMI’s net revenues (excluding excise taxes) in 2017, up from 3% in 2016.

PMI’s NGPs are showing promising performance following successful launches in Asia and Europe. But we think the related investments will keep capex and marketing costs at a higher percentage of sales than was historically the case. These investments have diluted margins, and we believe they will continue to do so until NGPs reach full maturity. We therefore think free cash flow is likely to be more limited than in the past.

These are inevitable consequences of the growing need to invest in innovation in order to defend revenues as cigarette sales decline. How far other tobacco companies will see similar adverse impacts on profitability and cash flow will depend on their willingness to invest in the category and ability to compete, and whether they can benefit from PMI’s work popularising heat-not-burn products.

We think that PMI’s efforts to open new markets (it is the only large tobacco company, along with Philip Morris USA, part of Altria Group, Inc. (A-/Stable), to have applied to the FDA to launch heat-not-burn in the US) will help preserve its first-mover advantage. But new entrants are increasing competition, meaning PMI may have to maintain its innovation and marketing efforts to continue justifying its price premium.

More broadly, the shift towards NGPs increases overall risks and uncertainties for tobacco companies. The potential for obsolescence and possible shifts in consumer preferences will be hard to control, and NGPs have cannibalised sales of combustible tobacco products. It is even possible that the industry will be transformed by NGPs or by regulatory changes.

While tobacco companies generally exhibit solid credit metrics, against this backdrop, financial flexibility has a value over the long term. The suspension of PMI’s share buyback since 2015, accompanied by slower dividend increases, indicates a willingness to protect the company’s credit metrics and prioritise the allocation of cash flow towards growing the NGP business. We expect that this approach will also be taken by the other tobacco players as they focus on NGPs, and we do not expect BAT or Imperial Brands to restart share buybacks this year, or to accelerate dividend growth.