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British American Tobacco - Reynolds bedding in

George Salmon | 26 July 2018 | A A A
British American Tobacco - Reynolds bedding in

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British American Tobacco plc Ordinary 25p

Sell: 3,460.00 | Buy: 3,461.00 | Change 22.50 (0.65%)
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Revenues and profits in British American Tobacco (BATS) half year results are significantly boosted by the acquisition of Reynolds American. However, investors will be pleased to hear underlying profits have come in ahead of expectations.

The group remains confident of delivering another year of adjusted earnings growth at constant exchange rates, and is optimistic a range of new launches can re-energise growth in heated tobacco products.

The shares rose 4.5% on the news.

The next quarterly dividend payment of 48.8p will be paid in August.

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Our view

Falling cigarette volumes are an inevitable fact in the tobacco industry.

So far BATS has been able to offset the decline through a combination of shifting smokers on to higher margin products and hiking prices. Dominant market position and an addictive product translates into tremendous pricing power.

The result has been impressively high margins and prodigious amounts of cash. Most of it can be returned to shareholders through dividends (which have grown every year since 1999) and share buybacks. The shares currently offer a prospective yield of 5.4%.

However, that yield is higher than it has been due to recent weakness in the share price.

That's partly because of fears over interest rate hikes. BATS and other shares with attractive dividends have been major beneficiaries of record low interest rates. Low rates have depressed yields on bonds, drawing income-starved investors from the bond market to defensive stocks like BATS, and ultimately boosting share prices. If rates rise quickly that trend could reverse.

There are industry wide headwinds too. Tobacco faces mountains of regulation, including the introduction of plain packaging in France, the UK and Ireland. Shortly after returning to the US via the acquisition of Reynolds, the regulator there announced plans to cut nicotine content in cigarettes.

An ever more hostile regulatory environment might explain why BATS has decided to spend big on Next Generation Products (NGPs) like e-vapour and heated tobacco.

These products are believed to cause less harm to users. A slowdown in the Japanese heated tobacco market, where Marlboro owner PMI's iQOS product has been very successful, isn't good news, but volumes are growing and BATS is clearly still optimistic.

At 12.8 times expected earnings the shares are trading at a meaningful discount to their longer term average - although above rival Imperial Brands. That's justified through BATS' presence in faster-growing emerging markets, as well as its strong position in NGPs.

Revenues from the 'glo' and 'Vype' heated tobacco and e-vapour brands are insignificant in the context of the wider group at the moment. But their fortunes are important. In an industry in terminal decline, long-term potential matters.

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Half year results (at constant exchange rates unless otherwise stated)

Reported revenues were £11.6bn, up 56.9% on the prior year. However, if you adjust for the Reynolds deal and currency movements (by adding Reynolds' results to the 2017 comparatives) revenue increased 1.9%. Growth came as a favourable price mix more than outweighed the 2.2% fall in volumes.

Operating profit of £4.4bn was up 72.4%, or 2.4% on an adjusted basis. Underlying margins increased 50 basis points.

BATS says Reynolds delivered a good performance. This has helped the combined group's US operation report an adjusted operating profit of £1.9bn, up 5.6%.

The Asia Pacific and Middle East region saw adjusted profits fall 5% to £1bn, as increased investment increased investment in new products and an unfavourable sales mix weighed on performance. The group's other geographies delivered collective profits of £1.6bn, with steady low-to mid-single digit percentage growth.

BATS' market share in 'key markets' increased 40 basis points, driven by the group's flagship brands. New heated tobacco products are growing strongly, up 855%, but remain less 1% of group volumes.

The Reynolds deal has pushed net debt up from £18.5bn this time last year to £45.7bn.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.