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British American Tobacco - Still growing despite falling volumes

Nicholas Hyett, Equity Analyst | 27 February 2020 | A A A
British American Tobacco - Still growing despite falling volumes

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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: 3,323.00 | Buy: 3,324.00 | Change 5.50 (0.17%)
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Full year underlying revenue rose 5.6% to £25.8bn at British American Tobacco (BATS). That reflects increased prices in traditional tobacco products, partially offset by lower volumes, and rising vapour and heated tobacco sales. Underlying operating profits rose 6.6% to £11.1bn.

The dividend rose 3.6% to 210.4p for the year as a whole.

The shares were broadly flat in early trading.

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Our view

Tobacco consumption in developed markets has been in declining for decades. However, the sheer size of BATs sales are still mind-blowing - if you put all the tobacco sold last year in standard sized cigarettes and laid them end to end you'd reach to and from the moon over 60 times.

That scale combined with incredible pricing power has resulted in operating margins other consumer goods companies can only dream of.

Dominant market position and an addictive product has repeatedly seen the group hike prices while moving customers onto premium products. With relatively low capital requirements the group's delivered prodigious amounts of cash despite falling tobacco volumes.

A lot of that cash is currently tied up in stabilising a balance sheet that's carrying considerably more debt than we would like, but it still 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 7%, although as ever there are no guarantees that can continue.

The major question facing the group, and the whole industry, is whether it can continue to squeeze ever more revenue from an ever smaller number of customers.

BATS is notable for its significant emerging market exposure, especially in Latin America and Asia which is a potential advantage when it comes to growth. But it's also got a strong position in the US, and that's a market with a surprising amount of potential. There's room for BATS to push up prices and grow margins across the pond, and since the US is by far the group's biggest region by revenue that would be good news for profits.

However, the tobacco industry isn't having things all its own way stateside.

Increasing regulation, particularly in US menthol, is a potential worry. There's been talk of banning menthol cigarettes completely, and given the dominant position of BATS' Newport Brand, this would be an unwelcome blow. Any drastic change in the law won't happen overnight, but it's certainly something investors should be keeping an eye on.

A prickly regulatory environment and falling tobacco volumes is why BATS has decided to spend big on New Categories like e-vapour and heated tobacco. These make up a small part of the picture at the moment, but are growing quickly and key to the long-term. Unfortunately, a spate of health scares in the US have significantly impacted the local vapour market. Interestingly, BATS is keen for more regulation here. It's no stranger to regulatory scrutiny after all, giving it a head start over newer competitors.

Emerging market exposure and a superior New Category position means BATS shares trade at 9.5 times expected earnings - ahead of its UK peers. However, that's significantly below its own longer term average, reflecting concerns that increased regulation could upset the apple cart.

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Full Year Results

Total cigarette volumes fell by 4.7% in the year to 668bn sticks, with larger contractions in the US, Europe and North Africa offset by better results in emerging markets. Revenue from traditional combustible tobacco products rose 4.6% to £23bn. BATS saw its share of the global tobacco market in key markets rise by 0.3 percentage points.

Total new category sales rose 32.4% to £1.2bn. Both vapour and heated tobacco sales performed well, up 23.4% and 22.7% respectively. However Modern Oral was actually the star performer, with sales of the tobacco free nicotine pouches rising 273.1% - albeit to just £129m.

Operating profits benefited from increased efficiencies across all categories, which funded the increased marketing spend in new categories and supported underlying margin gains. However, the group reported a number of exceptional costs including legal cases, impairments and restructuring costs totalling £2.1bn which hit reported numbers.

BATS reported operating cash conversion of 97%, with free cash flow after paying the dividend of £1.9bn. As a result net debt fell 3.9% to £41.7bn. The ratio of net debt to cash profits (EBITDA) fell to 3.6 times.

The group expects global cigarette and heated tobacco volumes to fall by 4% next year, with the US down 5%. However, despite that headwind the group expects to report 3-5% revenue growth with continued operating margin improvements.

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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 for more information.

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