British American Tobacco (BAT) has been blazing brightly lately. Shares are up 14% and 13% on the JSE and London Stock Exchange respectively over a month. Year to date the gains are a sprightly 19% and 18% respectively. That will blow smoke up those punters who dismissed BAT as a slowly smouldering dividend play. I’m ambivalent about BAT these days — tempted by a dirt-cheap valuation on a cash-generative vice, but equally turned off by a dirty and dangerous habit. In any event, my compromise is an indirect exposure to BAT via Reinet Investments. To be honest, if Reinet, which is now receiving dividends from its considerably bigger investment in specialist financial services, offloaded its BAT shares tomorrow, I would not be in the least bit fazed.
While a good number of market commentators seemed positive about the recent interim results, BAT’s half-year numbers to my mind also raise a couple of burning questions. The first centres on the growth in so-called new categories such as vapes, heated-tobacco products and modern oral products. These, contentiously, are being touted as healthier alternatives to the slowly extinguishing traditional cigarette market. BAT looks set to move its smokeless products to about 20% of total revenue by the end of this financial year. At the interim period the figure, which includes the traditional oral products, was 18% of revenue.
That’s a fair chunk of smokeless business, but sales growth in the new tobacco category has been slower than initially flagged. And at a profit level, the new category brands remain but a sliver. What will placate concerns around growth rates is that BAT’s new categories managed a profit contribution of £129m off revenue of £1.65bn. While the margin of just 8% is just a wisp compared with BAT’s core cigarette business, the profit number is more than respectable considering the competitive, and somewhat fragmented, market for new category brands. Whether they ever attain the enormous pricing power associated with the cigarette vice remains to be seen. For now, BAT is still in a heavy investment phase for the new category brands. Only once dominant market shares have been properly established will it be possible to make authoritative pronouncements on a sustainable margin.
At the recent investor call, BAT reassured that it remains a priority to balance revenue growth and margin expansion. This entails targeted investment in categories that have momentum and more value over both categories and geographies. In the short term, however, don’t expect fireworks. BAT is set to bring more product innovations to market in the second half, which will mean increased investment in that period. At best shareholders will see a bigger contribution from new products by the end of the financial year. The problem is that in the current climate margin fattening is not going to be easy.
It’s abundantly clear that BAT is peeved at the high levels of illicit product trading in the burgeoning new tobacco categories. The group noted that nicotine consumption in the US is still “pretty stable” but added: “The problem is that it’s growing where we are not able to participate nowadays, because these illegal vapour markets are accounting … for more than 60% of the vapour category.”
These illegal vapour markets are accounting … for more than 60% of the vapour category
Of course, this means that about £60bn of revenue could be up for grabs if there is strenuous and sustained enforcement against illicit products. Enforcement in a fast-growing and fragmented market is never easy, so I won’t be holding my breath for a regulatory fillip. Maybe as a South African I’m being overly cynical about enforcement; BAT did note the implementation of vapour directories in three US states, with an additional 10 states having passed vapour directory and enforcement legislation to date this year. More tangible was BAT’s observation of encouraging early signs of illicit product volume decline in Louisiana — the first state to implement a vapour directory and enforcement legislation, which it did last October. BAT reckoned its Vuse Alto brand captured the majority of the volume outflow back into the legal segment.
Since we are on the topic of great US pastimes, I was rather surprised to see small property group Texton Property Fund, where former Hosken Consolidated Investments prime mover Marcel Golding holds some sway, making an investment of close to R100m in the heart of tobacco country. Texton, via a UK-based subsidiary, intends buying 90% of an “infill class B standalone industrial property” in Winston-Salem in North Carolina.
Winston-Salem is the home of the old RJ Reynolds Tobacco Co, now owned by none other than BAT. Fully let on a triple net lease, the property will be bought on a nifty going-in yield of 7.8%. I wonder if Texton had this property in mind when it held its R85m rights issue at the start of the year. Texton now has a market value of just more than R1bn, so this is a meaningful US acquisition.
But it’s not as if Texton is a novice in offshore real estate investment. About 45% of the property portfolio is in the UK, and there is already a considerable indirect investment in the US property market via a handful of fund investments. The two biggest, Blackstone Real Estate and Starwood Real Estate, are valued at $12m and $11m respectively, so more than double the commitment to the Winston-Salem industrial stand.
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