Why British American Tobacco smoulders, for now

Can British American Tobacco (BAT) still be weighed up as a long-term habit?

The share arguably offers smouldering value at current levels, which are about 15% down from the R942 high in November last year.

By traditional investor metrics BAT appears to offer robust value; it’s on a trailing earnings multiple of about six and offers a yield from dividends (which are now conveniently paid every quarter).

Regulatory challenges, health issues and increasingly vehement social resistance to smoking perhaps justify BAT’s modest stock-market rating. This may work for investors wanting a three-to five-year fix — especially in prevailing market volatility.

At the recent investor presentation for interim results to end-June, BAT CEO Nicandro Durante was soothingly optimistic about medium-term prospects. He predicted another "good" financial year of adjusted earnings growth at constant exchange rates.

Durante noted the cigarettes and tobacco heated products (THP) portfolio had (again) outperformed the industry with market share growing 40 basis points (BPS).

There is also a reassuring tobacco price mix of about 4%, which is expected to strengthen in the second half.

Judging by queries at the investor presentation there were some concerns around the performance of recently acquired Reynolds American Inc (RAI). Durante was adamant RAI’s performance was in line with expectations.

Investors may disagree.

RAI enjoyed at best a mixed six months, and certainly did not have the same market-share gains as BAT’s traditional big brands like Pall Mall, Kent, Lucky Strike and Rothmans.

In the US, Newport grew market share by 10 BPS, but volumes were down 5.6%. Natural American Spirit grew market share by 10 BPS but also on lower volumes, while Camel market share fell 10 BPS with volume 3.2% lower.

This stands in stark contrast to the performance of what were previously known as BAT’s "global drive brands" (now dubbed strategic brands).

Kent increased market share 50 BPS and volume almost 9%, Lucky Strike pushed market share up 10 BPS and volumes 2% and Rothmans’ market share was up an impressive 80 BPS on a 34% volume shift. Pall Mall stretched its market share 30 BPS, with volume jumping 47% with the inclusion of RAI.

Overall BAT’s cigarette and THP (accounting for three billion sticks) volume fell 2.2% to 348 billion sticks — easily outperforming the industry, which was estimated to be down between 3% and 4% in the first half of 2018.

Cigarette volumes excluding THP were down 3.1% on a representative basis to 345 million sticks. But BAT’s strategic brands — whose margins are enhanced by pricing power — were up a sprightly 10% to 213 billion sticks on a representative basis.

BAT also appears to be powering ahead in the new generation products (NGP) segment where THP revenue of £305m was registered — growth of more than 750% compared with the first six months of 2017 (albeit off a low base).

Vapour (or vapes) revenue came in at £122m, which was in line with the previous interim period on a representative basis. Sales were, however, affected by a product recall related to a consignment of batteries in the US.

BAT said that if the recall were excluded, vapour revenue would have been up 8%.

Durante reckoned that despite a slowdown in key markets in the Far East, BAT would still register NGP sales of more than £1bn for the full financial year on the back of new product launches.

As things stand BAT looks capable of retaining pricing power in its key cigarette brands in a steadily diminishing market, which should buy it sufficient time to find critical mass in the expanding NGP segment.

Pricing-power scepticism is easily erased by interim period revenue growth of 1.9% to £12.55bn, and profit from operations edging up 2.4% to £5.2bn.

Of course, a fast-growing NGP segment will inevitably cut further into cigarette volumes, though BAT intimates this is not the case at the moment.

Dirk van Vlaanderen, associate portfolio manager at Kagiso Asset Management, says BAT’s conventional tobacco portfolio enjoyed a very resilient six months despite pro-forma volumes dropping 3.1%. He says pricing was an impressive 8% for the period. "We expect that this will likely accelerate into the second half."

Neil Brown, co-head of Electus, is also happy to draw on BAT. He says declining volumes should be expected in the years ahead.

"As usual, BAT is driving its strategic brand portfolio, where volumes rose by 10%, which was very good. Price rises were required to get revenue growth."

Brown notes that the adjusted operating margin increased by 50 BPS to 41.8% and believes an annual 50-100 BPS increase can be pencilled in for the short and medium term.

"We think BAT is undervalued and we continue to hold it among clients’ top holdings. However, the regulatory and legislative risk will continue so, longer-term, the key issue is how much pricing increases can be pushed to offset volume decline — while the NGP’s profitability will start off at zero in financial 2019."

While short-to medium-term prospects look sound (rather than spectacular) for BAT, investors need to accept that the traditional tobacco market is on a gradual course of terminal decline.

At some point, big tobacco companies will not be able to offset declining volumes with pricing power.

In terms of gauging the body language of large and well-informed tobacco-sector participants, there can be no better investment entity to follow than Reinet Investments — headed by the Rupert family, whose fortunes were largely built on cigarettes.

Reinet holds a 2.97% stake in BAT, and the group’s latest annual report reiterates that this investment is "kept under constant review, considering the company’s performance, the industry outlook, cash flows from dividends, stock-market performance, volatility and liquidity".

In his CEO review Johann Rupert said Reinet continues to take comfort from the underlying financial results, dividend and future prospects of BAT — including the investment in RAI, lower US tax rates and increased focus on NGPs.

Perhaps the question around BAT’s long-term investment status is best articulated by a top "sin sector" analyst who contends that BAT’s price on the London Stock Exchange (£41.52 at the time of writing) can creep up to £50 by end-2019.

"So I’m happy to hold it — but I’m not sure I want it in 10 years’ time," says the analyst, who asks not to be named.