PICK of the MONTH

British American Tobacco (BAT) can be a hard sell, particularly to the increasing number of “woke” investors.

Globally — barring a handful of emerging markets — cigarette sales are steadily being stubbed out. There’s frankly not much to debate about the potential health hazards of tobacco, and more stringent smoking regulations are increasingly snuffing out the last vestiges of social acceptability. Not surprisingly, BAT’s share price, which traded at more than R900 in May 2017, is now back at levels seen in early 2014.

But this is not all that has put out BAT’s blaze. The decision to double down on tobacco through the acquisition of US-based Reynolds introduced a hefty debt load, and caused the cessation of the aggressive share buy-back programme.

Another niggling issue is the perception that BAT’s main rival, Philip Morris (PM), is comfortably ahead in a race to build commanding market share in new-generation products (NGPs) like vapes, tobacco heated products (THP) and modern oral.

A recent report by JP Morgan maintained BAT was still several years behind it in NGPs and was entering an investment ramp-up phase for THP that would probably dampen earnings growth over the medium term.

But IM reckons BAT still represents smouldering value, with just the first glimpses of blue-sky potential in its fledgling NGP brands.

In the past financial year BAT showed solid performance from most of its traditional cigarette markets. It enjoys enormous pricing power in its key brands (probably understandable in view of tobacco’s habit-forming qualities).

The cigarette market will undoubtedly continue to shrink gradually year by year, but BAT — now with a more streamlined operating structure — will still receive rich cash flows from its traditional users for the foreseeable future. The trick now is to mobilise the chunks of cash flow not paid out in dividends or used to service (and repay) debt to build a new growth angle in NGPs.

It is difficult to gauge when BAT’s NGP segment will turn profitable. IM would guess break-even would be in 18 to 24 months, barring any unforeseen regulatory setbacks.

BAT recently reported that it already has 13.5-million consumers of its “noncombustible products” — having added a rather impressive 3-million consumers in Covid-19-disrupted 2020 alone.

The group reckons it is on track to have 50-million consumers by 2030.

BAT CEO Jack Bowles has told investors that the group’s NGP category grew revenue 50% in the second half of the financial year to end-December.

Still, BAT — to date — has not disclosed the quantum of the operating losses in the NGP business. That’s frustrating for investors, even if BAT executives reassured that the NGP losses will shrink markedly in financial 2021.

What investors do know is that BAT is sticking to some ambitious goals in terms of its NGP roll-out.

The envisaged growth acceleration across the NGP categories could cause BAT to push revenue from this niche to £5bn by 2025.

What will also buoy the company is an encouraging (albeit early-stage) thrust into e-commerce sales, which increased by 69% in 2020. Profitability in e-commerce is more than double in the traditional key accounts. There is also the shift into a cannabidiol (CBD) vaping product, Vuse CBD Zone, and more innovations around cannabis.

With the £5bn NGP sales target in mind, investors must not forget that BAT is a serious cash flow generator. In 2020 the group managed an operating cash flow conversion in excess of 95% — delivering £9.8bn of net cash generated from operating activities.

This realised £2.6bn of postdividend free cash flow in an environment hampered by the Covid-19 pandemic.

Now consider that BAT is ahead of schedule to deliver £1bn annualised savings by 2022, and investors should get some reassurance that the group has plenty of capacity to drive growth and innovations in the NGP categories.

Admittedly, it is still difficult to look past the billowing smoke of BAT’S traditional cigarette business. But the rate of top-line growth in the NGP brands in a multitude of international markets cannot be skimmed over.

IM suspects that investor attention will sharpen when BAT shunts the NGP category into profit, and (hopefully) provides more granular information for investors.

The X-factor remains the persistent whispering that BAT might separately list its NGP business on the Nasdaq . IM doubts any such move will transpire in the short term. But this talk certainly reinforces the notion that NGP innovation could prove rewarding for a business that has real geographic scale in its markets.

IM believes a little puff on BAT shares at current levels won’t hurt in the longer term. ●