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British American Tobacco - New Categories grow 50%

William Ryder, Equity Analyst | 28 July 2021 | A A A
British American Tobacco - New Categories grow 50%

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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: 3,541.00 | Buy: 3,542.00 | Change -85.50 (-2.36%)
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British American Tobacco's (BATS) first half revenue was £12.2bn, up 8.1% ignoring the impact of exchange rates. This reflects a 50% increase in New Categories revenue to £883m. Underlying operating profit rose 5.4% on a constant currency basis to £5.2bn.

BATS expects more than 5% revenue growth at constant currency for the full year, and mid-single digit constant currency earnings per share growth.

The shares were broadly flat following the announcement.

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Our view

Tobacco consumption in developed markets has been in decline 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 out end to end you'd reach to and from the moon almost 60 times.

That scale combined with incredible pricing power has resulted in operating margins other consumer goods companies can only dream of. What's more, demand for cigarettes has held up well during the coronavirus pandemic.

A 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 volumes.

A lot of that cash is currently going towards 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 to date) - but are never guaranteed.

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, 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. The UK, EU and Turkey have already made the move, although the impact has been "immaterial" as smokers just switched to other products. Investors may hope the group can similarly weather a US ban. Potentially even more concerningly, we're starting to hear whispers of nicotine limits - although these are still unconfirmed.

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.

Emerging market exposure and a superior New Category position means BATS shares continue to trade ahead of UK peer Imperial Brands. However, a valuation of 8.1 times future earnings, is significantly below its longer term average. We suspect the threat of increased regulation and the ever increasing number of investors seeking ethical investments is behind the valuation fall. They're not trends that are likely to reverse any time soon, and that makes a return to historic valuation levels unlikely. This means investors will probably need to rely on the dividend to earn a return.

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. It seems likely that the cash flows from traditional tobacco will eventually dry up, and it's not yet clear whether New Categories can carry the torch. It remains to be seen whether investors will collect enough dividends to justify their investment.

BATS key facts

  • 12m forward Price/Earnings ratio: 8.1
  • Ten year average 12m forward Price/Earnings ratio: 13.6
  • Prospective yield: 8.1%

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Results (Underlying and constant currency)

Overall Combustibles revenue rose 5.8% to £10.5bn. This was mostly driven by price increases, as volumes only rose 1.5%.

US revenue rose 9.1% to £5.6bn, primarily reflecting 8.1% growth in Combustibles to £4.8bn. This growth was driven by price increases, as Combustibles volumes fell 4.3%. New Categories revenue grew 55.1% to £243m, primarily thanks to the strength of Vapour, and the Vuse brand in particular, which closed the gap with the market leader. Operating profit rose 9.7% to £2.8bn.

Asia Pacific and Middle East revenues rose 5.8% to £2.1bn. Combustibles revenue rose 6.7% to £1.8bn, reflecting an 8.0% increase in volumes weighted towards lower value markets. New Categories revenue fell 1.1% to £228m, primarily reflecting the impact of THP excise tax payments in Japan, although THP volumes rose 23%. Operating profit rose 2.8% to £868m.

In Europe and North Africa revenue rose 5.9% to £2.8bn. Combustibles revenue fell 1.2% to £2.3bn as volumes fell 3.4%. New Categories revenue rose 113.5% to £358m, reflecting growth across all product categories, but exceptionally strong growth from THP following the glo Hyper expansion. Operating profit fell 3.7% to £892m.

In the Americas and Sub-Sahara Africa revenues rose 11.5% to £1.8bn, reflecting 8.7% growth from Combustibles to £1.7bn. Combustibles volumes rose 3.3%, driven by a recovery in several markets, most notably South Africa. New Categories revenue rose 74.8% to £54m. Operating profit rose 4.2% to £709m.

Free cash flow after dividend payments was negative £1.2bn, mainly reflecting the timing of investment thanks to Covid-19 and the deferral of US excise taxes. Adjusted net debt fell 8.5% to £40.5bn, or 7.6% to £40.9bn excluding the impact of exchange rates.

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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. 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.