Is BAT a bad habit?

Financial Mail - Investors Monthly - - Front Page - The writer is an un­re­pen­tant hoarder of sin stocks and holds shares in BAT

Is in­vestor sen­ti­ment be­ing snuffed out for Bri­tish Amer­i­can Tobacco (BAT)? The cig­a­rette gi­ant has been a port­fo­lio stal­wart for many lo­cal in­vestors who have man­aged to look past its ped­dling of po­ten­tially harm­ful and ad­dic­tive prod­ucts. BAT has de­liv­ered above-av­er­age cap­i­tal growth while con­sis­tently sat­is­fy­ing div­i­dend crav­ings.

David Lerche, se­nior in­vest­ment an­a­lyst at San­lam Pri­vate Wealth, says over the past 17 years BAT has de­liv­ered more than 13% com­pound an­nual div­i­dend growth in Bri­tish pounds, in­creas­ing its div­i­dend ev­ery year this cen­tury.

“This il­lus­trates its abil­ity to con­tin­u­ally im­prove mar­gins through op­er­at­ing ef­fi­cien­cies and mar­ket share gains, de­spite in­dus­try-vol­ume de­clines.”

But at the time of writ­ing, BAT had lost around 25% of its mar­ket value over the past three months on the JSE.

Some of the re­treat has been on the back of re­cent rand strength. But even on the Lon­don Stock Ex­change, where the group has its pri­mary list­ing, the share price has scut­tled down about 15% over the same

BAT dis­closed that to­tal group cig­a­rette and THP vol­ume grew 3.2% to 686bn, out­per­form­ing the in­dus­try — which was es­ti­mated to have de­clined by about 3.5%

pe­riod. This kind of down­ward drift is enough to make the hardi­est in­vestor start wor­ry­ing. What ex­actly is blow­ing smoke up the mar­ket? Could there be nasty de­vel­op­ments (like new reg­u­la­tions around tobacco prod­ucts or a dam­ag­ing law­suit) pend­ing? Did BAT get burnt on the re­cent Reynolds Amer­ica ac­qui­si­tion? Or are ri­vals build­ing a lead in de­vel­op­ing new gen­er­a­tion prod­ucts (NGPs)?

Per­haps the rea­son is far sim­pler and less sin­is­ter. Lerche be­lieves the mar­ket has lost its en­thu­si­asm for “bor­ing” con­sumer sta­ples com­pa­nies in re­cent months as US bond yields have risen, re­duc­ing the rel­a­tive at­trac­tive­ness of these com­pa­nies’ div­i­dends. “We see this as over­done.”

Fair enough. But com­mon sense, es­pe­cially to those not fa­mil­iar with BAT’s busi­ness model, would still dic­tate that smok­ing is a dy­ing habit — squashed by ( jus­ti­fi­able) health con­cerns and over­bear­ing nanny-state reg­u­la­tions on the tobacco in­dus­try.

As­tute in­vestors have been at­tracted to BAT mainly be­cause it holds a cap­tive (ad­dicted) mar­ket, thrives in a reg­u­lated en­vi­ron­ment and holds in­cred­i­ble pric­ing power in a shrink­ing mar­ket.

BAT also has an en­vi­able pres­ence in “de­vel­op­ing” mar­kets, a very as­tute man­age­ment team led by the un­flap­pable Ni­can­dro Du­rante as well as a stout bal­ance sheet (de­spite ex­tra gear­ing from the re­cent Reynolds Amer­ica ac­qui­si­tion)

and strong cash flows that sup­port a gen­er­ous (quar­terly) div­i­dend regime.

Re­sults to end-De­cem­ber once again showed smoul­der­ing profit growth and a 15% in­crease in the div­i­dend to £1.95/share.

What’s more there was a glow­ing out­look for the group’s NGPs — vapours (vapes) and tobacco heated prod­ucts (THP) — for smok­ers.

Rev­enue for the year was up 38% to £20.3bn af­ter the ac­qui­si­tion of Reynolds Amer­ica with earn­ings com­ing in around 10% higher at £2.84/share.

BAT’s GDB (global drive brands) — Kent, Lucky Strike, Dun­hill, Pall Mall and Roth- mans — com­bined with Reynolds Amer­ica’s strate­gic brands (Camel, New­port and Nat­u­ral Amer­i­can Spirit) con­tin­ued to grow mar­ket share in key ar­eas.

The GDB port­fo­lio grew 110 ba­sis points and now ac­counts for more than half of group cig­a­rette and THP vol­umes out­side the US.

BAT dis­closed that to­tal group cig­a­rette and THP vol­ume grew 3.2% to 686bn, out­per­form­ing the in­dus­try — which was es­ti­mated to have de­clined by about 3.5%.

Share­hold­ers fret­ting about the longer-term prog­no­sis for tra­di­tional com­bustible tobacco prod­ucts would take some com­fort in BAT’s stri­dent tones around prof­itably es­tab­lish­ing its NGP cat­e­gory.

BAT in­di­cated that NGPs gen­er­ated rev­enue of £397m, with Du­rante not­ing that if the con­tri­bu­tion from Reynolds Amer­ica was in­cluded (on a full-year ba­sis) the NGP rev­enue would have topped £500m.

He said BAT ex­pected NGP rev­enue to dou­ble in 2018 to £1bn, lift­ing to more than £5bn

The mar­ket has lost its en­thu­si­asm for ‘bor­ing’ con­sumer sta­ples com­pa­nies in re­cent months as US bond yields have risen

by 2022.

IM stum­bled on a dis­tinctly bear­ish note on BAT that was pub­lished last month by New York-based in­vest­ment re­search firm Seek­ing Al­pha’s web­site by Bears of Wall Street (BOWS) — which pen­cils in a down­side of 25%-30% from the cur­rent mar­ket price. In JSE terms that would sug­gest a R525 share price for BAT — a level that would push the earn­ings mul­ti­ple and yield to eye­brow-rais­ing lev­els.

BOWS ar­gues that most of the profit growth im­pe­tus came from the ac­qui­si­tion of Reynolds Amer­ica with BAT’s

The ac­qui­si­tion of Reynolds Amer­ica shifts BAT’s ex­po­sure to­ward a more prof­itable and less com­pet­i­tive re­gion

or­ganic prof­its up only 3.7% year-on-year (thanks mainly to the weaker pound).

It does seem that Reynolds Amer­ica is spark­ing nicely for BAT.

Dirk van Vlaan­deren, as­so­ciate port­fo­lio man­ager at Kag­iso As­set Man­age­ment, says Reynolds Amer­ica has traded well so far un­der BAT’s ste­ward­ship — grow­ing share in the se­cond half and re­al­is­ing US$70m of the ex­pected $400m cost syn­er­gies. He says changes in the US tax regime of­fered a size­able earn­ings and cash flow boost in 2018.

“BAT is us­ing half of this wind­fall to rein­vest be­hind the growth of the busi­ness and next gen­er­a­tion prod­ucts.”

Lerche says the ac­qui­si­tion of Reynolds Amer­ica shifts BAT’s ex­po­sure to­wards a more prof­itable and less com­pet­i­tive re­gion as well as a mar­ket where it is the clear leader in the va­p­ing space.

BOWS cau­tions that other mar­ket par­tic­i­pants from the tobacco in­dus­try have posted earn­ings that were not as good as the mar­ket ex­pected.

Al­tria an­nounced re­cently that its fourth-quar­ter rev­enues were down on an an­nual ba­sis, which re­sulted in its de­ci­sion to set a full-year profit guid­ance be­low mar­ket ex­pec­ta­tions.

BOWS says while BAT’s rev­enue would grow slowly, its profit lines would be volatile from time to time due to ex­ter­nal fac­tors, in­clud­ing new tobacco-re­lated rules.

But Lerche reck­ons BAT’s global scale in dis­tri­bu­tion and man­u­fac­tur­ing, cou­pled with its lead­ing tech­nol­ogy, po­si­tions it well to mi­grate many of its cig­a­rette cus­tomers to NGPs over the com­ing decade.

“In an in­dus­try where ad­ver­tis­ing is largely pro­hib­ited, BAT’s strong ex­ist­ing brands pro­vide high bar­ri­ers to en­try.”

Van Vlaan­deren says BAT has an ex­cit­ing next-gen­er­a­tion prod­uct of­fer­ing and a broad strat­egy to tar­get the vapour and THP seg­ments.

He says sev­eral years of re­search and de­vel­op­ment and $2.5bn of in­vest­ment is fi­nally begin­ning to bear fruit, with strong vapour mar­ket shares be­ing achieved in the US, the UK and Poland and a grow­ing

num­ber-two po­si­tion in tobacco-heated prod­ucts with its “glo” prod­uct in Ja­pan.

“With ca­pac­ity in­creases ex­pected and new prod­uct in­no­va­tions to be launched in the se­cond half of 2018, we would not be sur­prised if BAT ex­ceeded its £1bn rev­enue tar­get from next gen­er­a­tion prod­ucts in 2018.”

Lerche adds that NGPs of­fer cus­tomers a “nico­tine fix” with a 95% re­duc­tion in harm­ful chem­i­cals. “Man­age­ment ex­pects NGPs to ac­count for al­most a fifth of group rev­enue in the next five years.”

On the key is­sue of pric­ing power, Van Vlaan­deren says BAT’s pric­ing range of 5.5% is in line with his­tor­i­cal av­er­ages and at the up­per end of the com­pany’s tar­get of 4%-6%. “Ad­mit­tedly, this was slightly be­low the height­ened level of 2016. But this is not a bad re­sult given some of the pric­ing head­winds and ex­cise-in­duced down­trad­ing in some of BAT’s key mar­kets such as Rus­sia.”

Van Vlaan­deren says the tobacco pric­ing equa­tion re­mains struc­turally ro­bust and could be fur­ther en­hanced by the in­tro­duc­tion of NGPs.

Fun­da­men­tally, it is dif­fi­cult to fault BAT’s model. There will be no fire­works, but a pre­de­clared quar­terly div­i­dend timetable un­der­lines man­age­ment’s con­fi­dence in BAT’s abil­ity to con­tinue gen­er­at­ing strong cash flows and high sin­gle-digit earn­ings growth.

Lerche is adamant that BAT’s long-term re­turn on eq­uity war­rants a higher val­u­a­tion than the mod­est for­ward earn­ings mul­ti­ple — given the ex­cel­lent con­ver­sion of ac­count­ing prof­its into cash. “We ex­pect earn­ings per share to grow by 9%/year in pounds for the next three years.”

He says BAT trades at a free cash flow yield of more than 7% and of­fers a div­i­dend yield of about 4.5% in pounds. “This is at­trac­tive rel­a­tive to the group’s own his­tory, its tobacco peers and global con­sumer­sta­ples peers.”

Ad­mit­tedly it’s never easy hang­ing on to a share when the mar­ket — for no good rea­son — makes a habit of mark­ing down the price.

Fin­gers may get burnt in the short term, but over a longer pe­riod BAT is a vice worth keep­ing.


Dirk van Vlaan­deren

David Lerche … Im­prove mar­gins


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