Market Report: Tobacco pricing power 'is running out of puff'

Tobacco stocks missed out on the stellar gains registered by blue chips yesterday as investors were unnerved by a warning from ABN Amro that the industry might be losing its pricing power. Such talk left Gallaher 11p lower at 854p, BAT off 9p at 1,269p and Imperial Tobacco 9p weaker at 1,690p.

The Dutch broker's warning was certainly stark. It suggested that in western Europe, a key part of the world for most cigarette makers, the industry's pricing power is fast evaporating and that this problem is particularly acute in Germany, France and Spain. ABN pointed to complaints about this phenomenon from a series of tobacco executives over the past few months. Most recently, Gareth Davis, the chief executive of Imperial Tobacco, said: "We've seen much more price aggression in the last two years than we would normally have done."

All this spells bad news for tobacco shares, according to the broker. Pricing power has been the key market characteristic that sets tobacco apart from other consumer sectors. It is particularly important to cigarette makers today as they increasingly come up against falling volumes in developed markets. Without pricing power, earnings at the likes of BAT and Gallaher will suffer, ABN says, and if its decline continues the tobacco sector will start to look expensive.

Hence, the Dutch broker downgraded all the main industry players yesterday. It cut its recommendation on Gallaher to an outright "sell" and on BAT and Imperial to "hold" from "add". However, those investors with exposure to the sector cannot complain. Since 2001 it has outperformed the wider market by 400 per cent.

Meanwhile, bulls once gain took control of the FTSE 100, driving it 42.7 points higher to 5,731.5. Compass rose 4.75p to 235.25p after the fellow European catering giant Sodexho posted solid first-quarter sales figures. The mining sector rebounded after Tuesday's heavy losses, helped by upbeat comments from Goldman Sachs. Rio Tinto rose 85p to 2,719p, BHP Billiton gained 12.5p to 978.5p and Anglo American added 24p to 1,973p as the US broker upgraded its earnings forecasts for the trio.

Deutsche Bank got its clients interested in Lloyds TSB, 9.5p higher to 505p, Barclays, 7.5p better to 626.5p, Royal Bank of Scotland, up 25p to 1,802p, and Northern Rock, 14p better to 945p. The German broker raised its stance on the four to "buy".

However, Persimmon, down 16p to 1,244p, suffered at the hands of Deutsche as it argued that the whole sector "now feels to us fully valued".

A profit warning from Bovis Homes, 17.5p weaker at 752p, negatively impacted sentiment towards housebuilders. Hence, Bellway dropped 8p to 1,157p, Taylor Woodrow retreated 3.25p to 380.75p and George Wimpey lost 2p to 465.5p.

ITV lost 0.75p to 116p as Morgan Stanley downgraded its rating on the broadcaster to "underweight" from "equal weight" and suggested that the recent jump in the stock, prompted by takeover rumours, provides investors with a great selling opportunity. The broker said: "We suspect ITV will underperform the market in 2006." Morgan Stanley sees advertising revenues at the group as vulnerable to further downgrades and described its move into new growth areas, such as the internet, as "interesting, but not big enough".

Takeover rumours circled Unilever, 10p higher at 591p. Gossips talked of a possible bid for the consumer goods giant from the US giant Kraft Foods. Emap fell 7.5p to 855p on rumours the media group might soon be forced into issuing a profits warning. The company publishes consumer magazines, a market where trading conditions are far from bullish at present, and is know to be having trouble with its French business. However, analysts were far from convinced that a profit alert is imminent.

London Stock Exchange jumped 43p to an all-time high of 658p as a series of brokers applauded Tuesday's bullish update from the bourse. Credit Suisse First Boston said: "We believe the LSE remains fundamentally undervalued versus peers in the stock exchanges space".

Uniq ticked 4.25p higher to 111p on talk the food group is close to finding a solution to its pension fund deficit.

Z Group put on 4.5p to 102p after announcing the launch of a new product that speeds up consumers' broadband connections to the internet by up to five times. Investors can expect further positive newsflow from Z Group in the next few weeks.

Finally, Pipex Communications added 0.45p to 12.20p as Merrill Lynch came away from a visit to the broadband internet provider with the view that it is vulnerable to takeover.