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British American Tobacco - On track for the full year

Nicholas Hyett | 12 June 2019 | A A A
British American Tobacco - On track for the full year

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No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

British American Tobacco plc Ordinary 25p

Sell: 2,653.00 | Buy: 2,655.00 | Change -15.50 (-0.58%)
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Full year guidance remains unchanged, with strong performance from both traditional tobacco and New Category products. Price growth continues to offset volume declines, with group net debt declining.

The shares fell 1.5% following the announcement.

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Our view

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

So far British American Tobacco (BATS) has been able to offset the decline through a combination of shifting smokers onto 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. That's crucial to stabilising a balance sheet that's carrying considerably more debt than we would like, but also leaves a sizeable surplus that 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 6.8%, although as ever there are no guarantees.

However, the other inevitable fact in tobacco is regulation, and on that front things are looking less rosy.

The acquisition of Reynolds gave BATS a dominant position in US menthol. That's a segment that's been in regulators sights for some time - thanks to its perceived status as a gateway for new smokers. The FDA are now considering banning them altogether. While many menthol smokers would likely move over to non-menthol products, it would still be a major blow.

A 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, but even here the US regulator is creating waves - potentially banning flavoured capsules popular with younger customers.

Revenues from heated tobacco and e-vapour brands, like 'glo' and 'Vype', are small in the context of the wider group but growing rapidly. In an industry in terminal decline, long-term opportunities are of outsized importance.

At 9.6 times expected earnings, BATS shares are trading on a PE ratio well below their longer term average, but significantly above fellow tobacco giant Imperial Brands. We put that premium down to BATS' superior position in NGPs, as well as potentially attractive emerging market exposure. Given the level of debt and regulatory crackdown in developed markets, those positions could prove crucial to sustaining the dividend in the future.

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First Half Trading Update

Global tobacco volumes are expected to decline by around 3.5% this year.

However, British American Tobacco (BATs) is on track to deliver revenue growth at the upper end of its 3-5% guidance range. That reflects a slight increase in BATs' share of total global tobacco value, as price increases offset declines in volume.

BATs expects to see a 'good improvement' in margins, with adjusted operating profit growth towards the upper end of the 5-7% guidance range.

New Categories, which includes heated tobacco, vapour and modern oral, is on track to deliver revenue growth in the 30-50% range, with good results from the Vuse, Vype and glo brands.

The US remains a challenging market, with industry volumes down 4-5%. However, BATs has grown its share of the market - as measured by value - with Strategic Brands delivering particularly strong results.

Group net debt stood at £44.4bn at the end of last year, around 4 times net debt to EBITDA (earnings before interest, tax, depreciation and amortisation). BATS says it expects that ratio to fall by around 0.4 per year, with free cash flow after dividend payments of £1.5bn this year.

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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. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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 disclosure for more information.