It’s not easy to kick old habits, and British American Tobacco (BAT) looks like it’s having a tough time convincing investors that its various alternatives to unhealthy cigarettes will keep profits blazing.
BAT’s traditional cigarette business crimped further in 2020 (by almost 5% in volume).
The thing is, this wheezing category still has considerable pricing power and continues to underpin the group’s powerful cash flows.
Logically, though, the cigarette market will shrink to levels that no amount of pricing power can sustain — which is why BAT is investing heavily in less harmful next-generation products (NGPs).
According to The Observer newspaper, BAT is spending an eye-popping £1bn to harness "the popular appeal of social media influencers, pop stars and sporting events".
The tobacco market, after all, is huge: The Observer says there are 500-million nicotine consumers, with £100bn a year to spend.
Not surprisingly, the repeated refrain in BAT’s latest investor presentation is that financial 2021 will be a pivotal year.
BAT is hoping to convince investors that it has found enough sustainable traction in NGPs to justify using the cash flows from its smouldering traditional cigarettes business to invest in growing brands like Vuse (e-cigarettes), Glo (tobacco heated products or THPs) and Velo (nicotine pouches).
But the market is doubtful: BAT’s share price on the London Stock Exchange suggests positive sentiment is slowly being stubbed out.
Its shares have retreated more than 10% on a year-to-date basis, and are now less than half of the £55.92 seen in mid-2017.
While smoking is a diminishing habit – at least in Europe and North America – BAT has persistently been held up as an example of a defensive stock for investors determined to build value at low risk. BAT still has commendable investment attributes: a strong management team, an enviable spread of international markets, an efficient operating structure, and redoubtable and habit-forming brands (Pall Mall, Newmont, Lucky Strike to name a few).
Ultimately, these attributes all help BAT generate heaps of cash flow and maintain a generous dividend policy.
In the year to end-December 2020, BAT delivered £9.8bn of net cash generated from operating activities — realising £2.6bn of post-dividend free cashflow despite a £131m hit to working capital from Covid-19 side-effects.
So on paper, BAT should be fodder for widows and orphans.
But it might be that investors, especially those with an eye to a longer-term horizon, are asking if BAT is at a vulnerable inflection point.
The numerous references to "pivotal year" by BAT CEO Jack Bowles during last week’s investor presentation might betray an underlying tension in the restructuring of BAT, from a cigarette vendor to a multicategory fast-moving consumer goods (FMCG) business "with a reduced risk to public health, driven by evolving consumer needs".
It is the "evolving consumer needs" that introduce elements of uncertainty around BAT. The NGP market is in its infancy, and it’s clear BAT has a stern competitor in Philip Morris.
BAT has not disclosed the quantum of the NGP losses in its detailed financial statements. Still, the breakdown at the revenue line is fascinating, especially in terms of assessing the medium-term NGP goals.
BAT’s total annual revenue reached about £26bn for 2020, with the traditional cigarette business accounting for almost £23bn of this number.
The noncombustible businesses mustered sales of £2.6bn, but £1.1bn of that is generated by the traditional oral business. Sales in NGPs (vapours, THP and modern oral) were less than £1.5bn, or just 6% of total revenue.
This performance gives context to BAT’s goal of NGP revenue of £5bn in 2025 — and really means an ambitious growth goal of more than tripling of sales in this niche in five years. The annual growth rate will need to be a brisk 25%-30%.
This is not easy when the so-called healthier alternative tag is consistently challenged by anti-tobacco lobbyists.
Still, BAT already has 13.5-million consumers of noncombustible products, and Bowles believes the group is on track to hold 50-million customers by 2030.
In 2020 the growth rate in NGPs was around 15%, with vapours up 58%.
During the presentation there were quite a few reassurances that losses in the broader NGP portfolio would be cut, even with these ranges being expanded.
Goldman Sachs analyst Richard Feltman tried to pry for more detail on NGPs by asking if the broader category had an improvement in gross margins in 2020.
Bowles said BAT had improved distribution costs and honed its marketing efficiency.
"That’s why we say that for 2021 we will not only continue to invest at a high level in new categories, but we will start to reduce our losses in terms of new categories."
Whether NGPs will ever have the remarkable pricing power of cigarettes remains to be seen.
Questions were also raised around whether vapour or THP would reach break-even first. Bowles noted that both were improving "sequentially", adding that profit might depend on the taxation environment.
"We see more tax acceleration in THP at the moment."
Jonathan Leinster of Société Générale pitched another niggling inquiry about the NGP growth projections – noting that a competitor (Philip Morris) was talking about generating half its revenue from NGPs by 2025.
Leinster said this implied an NGP business that would be two or three times bigger than BAT’s envisaged R5bn NGP business. "Is your target ambitious enough?"
Bowles deflected defensively.
"We take it step by step. We have a very strong start, and we’re happy with that and then we’ll navigate as we go along. Our numbers are our numbers, and we’ll develop as we go along."
BAT finance director Tadeu Marroco was a tad more forthright.
He disclosed that in a key market like Japan, 40% of revenue was already derived from noncombustible products. "You go to Sweden, it’s 40%. The UK is 30%. This is happening in a number of markets. We have a very strong footprint across the world."
Clearly there is lot to deliver on in this pivotal year, and the FM reckons there will be more than a few shareholders clamouring for sales updates at the upcoming AGM.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.