British American Tobacco: Thank you for not smoking

Cigarette giant British American Tobacco (BAT) seems determined to stub out its traditional business, telling consumers last week that the best way to avoid the health risks of smoking is not to pick up the habit or simply to quit.

That might sound like commercial suicide with BAT owning Dunhill, Kent, Lucky Strike, Pall Mall, Camel, Benson & Hedges and Newport — some of the most iconic international cigarette brands.

But BAT is increasingly putting store in its new-generation products as a healthy alternative to combustible cigarettes. These products include vapours (or vapes), tobacco heating products (THPs) and modern oral products.

The new category brands endured a sluggish half-year to end-June, with the sprightly growth of previous periods muted in interim trading by Covid-19 complications.

But BAT CEO Jack Bowles still believes the group is capable of generating new category revenue — derived from brands such as Vype, Vuse, glo and Velo — of £5bn (about R100bn) by 2025.

Cigarette sales, £10.85bn in the half-year to end-June, still account for 88% of BAT’s total sales, and generate the bulk of the group’s cash flows.

While cigarette volumes have continued their steady decline, BAT has shown remarkable pricing power in its key brands to allow value gains to offset the shrinking volumes.

With this in mind, it might be a little disarming to see that in BAT’s latest trading statement, Bowles is adamant that combustible cigarettes pose serious health risks. "And the only way to avoid these risks is not to start or to quit. BAT encourages those who would otherwise continue to smoke to switch completely to scientifically substantiated reduced risk alternatives."

Bowles said BAT already boasts 13-million noncombustible-product consumers. "We are continuing to increase investment in our three new categories of potentially reduced risk cigarette alternatives."

The group has stated a goal of 50-million new category consumers by 2030. In the half-year to end-June, noncombustible products accounted for 10% of BAT’s total revenue, with a 13% increase in sales to £1.2bn.

At last week’s investor presentation, financial director Tadeu Marroco said BAT has taken the opportunity to further increase new category investments in the second half by close to £200m. He said this represents a total additional new category investment of about £450m in 2020.

As for BAT’s longer-term new category ambitions, Gaurav Jain, an analyst at Barclays, says the £5bn target by 2025 implies new growth would be about £700m a year compared with the £200m-£300m growth of the past two to three years. He asks: "Does it require a significant step up in the growth rate and investment in new category products?"

Marroco said BAT’s strong traditional cigarette business as well as further cost savings would generate the funds necessary to fulfil the growth in new categories.

In terms of assessing the realism of BAT’s longer-term sales goal for new category products, Marroco stressed that 2020 has been a peculiar year with a number of headwinds, including Covid-19 disruptions to supply chains in China as well as the closing of shops in Europe and Japan.

"So we cannot read much through the numbers in absolute terms as regards the 2020 end goal. We are growing our share in every single one of those categories. In vapour, we are leading four out of the five top markets and making big inroads in the US. In modern oral, we are solidifying our leadership outside the US. In THP we are getting close to 20% volume growth ... So I think that this gives us the reassurance that we’ll be able to achieve our £5bn target by 2025."

Rey Wium, an analyst at SBG Securities, asked whether the new category segment would get "a bit of an acceleration" in second-half revenue.

The only way to avoid [health] risks is ... to quit. Those who [want] to smoke [should] switch to scientifically substantiated reduced risk alternatives

Marroco said BAT did not provide guidance for revenue growth for new categories for this financial year (to end-December). "We had a 12% increase in the first half of the year, and we are saying that we accelerated in the second half. We are expecting to perform better in the second half than we did in the first half."

He did warn, though, that all BAT’s vapour stores closed again across Europe in the second Covid-19 lockdown.

One of the key questions at the investor presentation was about BAT resuming its share buyback programme — something which was actively pursued before the group geared up to acquire the Reynolds business in the US.

Wium asked for clarification about whether BAT would revisit its share buyback programme once the net debt to earnings before interest, tax, depreciation and amortisation ratio was closer to three times.

Marroco cautioned such an assumption would be "getting ahead of the game". He said capital allocation is constantly reviewed. "We are clear, for the year to come, that we want to strengthen our balance sheet ... and we want to continue investing in new categories and continue doing the dividends at the 65% payout level."

Marroco said that by the time BAT reaches the three times leverage level, there will be more flexibility to put matters such as share buybacks back on the table.

"But this will depend a lot in terms of the valuation of the company at that time as well. So, a number of factors are in play."