British American Tobacco plc (BATS) Ordinary 25p

British American Tobacco's (BATS) 2023 revenue grew 3.1% organically to £27.3bn, when ignoring currency movements.

21% growth in new categories such as vapes was the main driver of growth. Sales in the much larger combustibles category were flat, as volume declines, particularly in the US, were offset by strong pricing elsewhere.

Underlying operating profit rose in line with sales to £12.5bn.

Free cash flow increased by 3.9% to £8.4bn. Net debt at the year end was £34.6bn.

Dividends for the year were up 2% to 235.52p per share.

For 2024, BATS is expecting low single figure growth for both organic revenue and underlying operating profit, with performance to be weighted to the second half.

The shares were up 6.7% in early trading.

HL 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. It also leaves room to support an attractive dividend yield which, following a persistent decline in the company's market value, is now touching double digits. But share buybacks remain on hold and are unlikely to be reconsidered until net debt drops a little further. A sell-down of the stake in India's ITC, worth about £14bn at market prices, could see this brought forward. But neither that, nor indeed any shareholder distributions can be guaranteed.

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,

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. 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 disclosure for more information.

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