Is BAT a bad habit?
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
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