British American Tobacco plc (BATS) Ordinary 25p

British American Tobacco reaffirmed its guidance for 2024 at its AGM. It continues to anticipate low-single digit organic growth in revenue and underlying operating profit, despite currency headwinds. Performance is expected to be weighted towards the second half for both revenue and profit.

Looking ahead, by 2026 the business expects to deliver 3-5% organic revenue growth and mid-single digit organic growth in underlying operating profit.

Since year-end, the company has made a part disposal in India’s ITC. The close to £1.6bn of net proceeds are being distributed via a share buy-back program with £0.7bn earmarked for this year and £0.9bn in 2025.

The shares were broadly flat following the announcement.

Our view

British American Tobacco is fighting hard to maintain market share in traditional combustible products (cigarettes and cigars) in its largest market, the United States. This is proving challenging and it's weighing on financial performance. In other territories the picture looks brighter. There are also rays of hope that BATS' efforts to stem the tide in the US are bearing fruit. But it's against the backdrop of a declining market. For the immediate future, combustibles remain the key driver of profitability so any further slowdown could further dent investor sentiment.

The group was early to recognise changes in consumer behaviour and is increasingly pinning its hopes for the future on its portfolio of 'smokeless' products, namely vapes, heated tobacco and oral pouches. We're impressed by the progress made so far. These New Categories are set to reach profitability in 2024, two years ahead of the original plan. There's now a target in place for them to generate over half of total revenues by 2035. We admire the ambition but there will be challenges along the way. There is some evidence to suggest that these products pose a reduced health risk compared to cigarettes, but they are coming under increasing scrutiny with some products banned in the US earlier this year. There's also mounting pressure for higher taxes going forward.

The company itself has called out the trade in illicit disposable devices as an immediate concern, and there's no certainty that enforcement will improve. It's too early to call how the long-term profitability of these products will compare to traditional products. This could undermine BATS' attractive operating margins which have remained over 40% despite recent market challenges and the spike in inflation.

Consistently high cash flows do mean that the company is well placed to make the investments necessary to keep pivoting away from cigarettes. That also supports a double-digit dividend yield.

The part sale of the stake in India's ITC, raised proceeds of nearly £1.6bn, which are being returned to shareholders through a share buy-back. Selling down the remaining share, or meeting target debt levels of 2-2.5x underlying cash profit (EBITDA) could see a further step up in shareholder pay outs. There can be no guarantees of further payouts to shareholders.

Whilst the yield remains a key lure for investors, recently it hasn't been enough to compensate for capital losses. The weakness seen in the valuation suggests that there's still a job to be done in convincing investors that New Categories can underpin BATS' future. Successful execution of the strategy could well drive a re-rating. Things are certainly moving in the right direction, but there are likely to be bumps along the way, so investors need to be prepared for some volatility.

Environmental, social and governance (ESG) risk

The food and beverage industry tends to be medium-risk in terms of ESG though some segments like agriculture, tobacco and spirits fall into the high-risk category. Product governance is a key risk industry wide especially in areas with strict quality and safety requirements. Labour relations and supply chain management are also industry wide risks, with other issues varying by sub-sector.

BATS' overall management of ESG issues is strong according to data by Sustainalytics. But we do have some concerns. Recent controversies include accusations of using corporate social responsibility activities to influence government officials and bypass tobacco policies. With tobacco being on the exclusion list of certain institutional investors, product impact is key and the company's commitment to public health.

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