British American Tobacco PLC (LON: BATS) – New Category to drive future growth

British American Tobacco PLC is a global tobacco company that has a portfolio of brands that include combustible tobacco products, traditional oral products and non-combustible tobacco products. The Company provides adult consumers with a wide range of enjoyable and less risky products. Under the Non Combustible segment it categorises the business under New Categories and Traditional Oral, and in the Combustible segment, it includes Combustible Tobacco products. The Company brands the vapour products under Vuse, modern oral products under Velo and tobacco heating products under Glo. Some of the key cigarette brands under the portfolio are Dunhill, Camel, Vogue, Viceroy, Kool, Peter Stuyvesant, Craven A, State Express 555 and Shuang Xi. BATS is listed on the FTSE-100 index.

On 17 February 2021, the Company will publish the preliminary results for the year ended 31 December 2020.

(Source: Company website)

Growth Prospects and Risk Assessment

BATS is focussed on the New Category products, which is supported through investments from the funds generated through traditional tobacco business. The Company is targeting the non-combustible category for growth, and it is eyeing 50 million non-combustible consumers by 2030. As a part of its growth strategy, the Company recently acquired Dryft Modern Oral business, which is into nicotine pouch product assets. The US has a fast-growing nicotine market, and the Company is looking to strengthen its position there through acquisition and product expansion. The non-combustible segment adds close to 10% of the Company revenue with 11.6 million customers, but by 2025, the Company is targeting revenue of £5 billion from the New Category segment.

Over the long-term, the Company is committed to dividend growth and increase pay-out ratio, which it plans to achieve through disciplined capital allocation. The Company is venturing into the non-combustible business through partnerships and small scale mergers & acquisitions. The Company would deliver working capital efficiencies and savings are expected to be around £1 billion between 2020 and 2022.

BATS has delivered a strong sales growth as its revenue has grown at a CAGR of around 18.5% between FY2015 and FY2019 and the diluted earnings per share have grown at a CAGR of nearly 2.0% in the same period.

(Source: Company website)

Meanwhile, the Company is exposed to health related risks, and it is putting strenuous efforts through its strategy to reduce the health impact on the business. The Company is cognizant of the fact that combustible products pose a significant health risk and thus from a social aspect, it states that the only way to avoid these risks is not to start or to quit. The Company is also exposed to regulatory norms and higher taxes related to the tobacco sales. 

Industry Outlook Dynamics

The global cigarette and THP industry volume is expected to decline by close to 7% in 2020. The US industry volume is expected to be down by around 2.5% in 2020, which was previously expected to be down by 4%. The US industry volumes are expected to be better than the previous forecast due to resilience in consumer demand and higher trade stock levels following covid-19. The restrictions in travel will affect the business of the travel retail business for the tobacco industry.

After understanding the industry dynamics, we will analyse some key fundamental and shareholders statistics of British American Tobacco Plc.

Recent Developments

On 3 November 2020: The Company announced that its US business had acquired the Dryft Sciences, LLC. It will expand BAT's Modern Oral portfolio in the US market, with adding 28 product variants and also will expand portfolio in nicotine.

On 15 October 2020: BATS announced the appointment of Luc Jobin, as a Chairman of British American Tobacco Plc. Luc will succeed Richard Burrows. Mr Burrows will retire from the Board at the end of the Company's 2021 AGM.

A Glimpse of Business Segments

(Source: Company Website, chart created by Kalikine Group)

Financial Highlights (for the six months ended 30 June 2020 (H1 FY20), as on 31 July 2020)

(Source: Company Website)

• The Company highlighted that the sales volume of global cigarette and tobacco heating product to remain passive in 2020.
• BATS’s revenue surged by 2.4% year-on-year (on a constant currency basis) in H1 FY20, with an increase in combustible revenue and the new category revenue of 2.2% and 12.7%, respectively.
• In the new category revenue, BATS has a target of £5 billion for 2025.
• Based on the regional performance, the adjusted revenue from the US and ENA (Europe & North Africa) regions increased by 9.7% and 3% year-on-year, respectively, whereas AMSSA (Americas & Sub-Saharan Africa) and APME (the Asia Pacific & Middle East) revenue declined by 0.9% and 10.5% year-on-year, respectively.
• The cigarettes price mix surged by 8.5% year-on-year that lowered the negative effect of 6.3% in sales volume of cigarette and tobacco heating products.
• The operating margin improved from 42.9% in H1 FY19 to 43.7% in H1 FY20, following a 4% positive impact of pricing and operational efficiencies, whereas negative impact was due to incremental new categories and translational foreign exchange.
• Reported basic and diluted earnings per share increased by 22.7% to 151.2 pence and 150.7 pence, respectively.
• Net cash generated from operating activities surged by 52% year-on-year, mainly driven by the deferral of total excise and corporate tax payments.
• Led by the bond issuances in H1 FY20 and weakness in a foreign exchange transaction, the borrowings increased to £50,461 million as compared with the previous period (31 December 2019: £45,366 million).
• Strategic Cigarette and THP (Tobacco Heating Product) volume decreased by 3.4%, with an increase in value share of 40 bps and volume share of 30 bps. It also witnessed a growth in all the regions.
• It also anticipates the operating cash conversion to be more than 90% in 2020.
• The Company expects the revenue to grow between 1% and 3% in FY20 with earnings per share growth in the mid-single-digit.

Financial Ratios

Share Price Performance Analysis

On 30 November 2020, at the time of writing (before the market close, at 8:02 AM GMT), British American Tobacco Plc shares were trading at GBX 2,649.00, down by 1.05% against the previous day closing price. Stock 52-week High was GBX 3,507.00 and Low of GBX 2,362.50, respectively.

From a technical standpoint, we could see a positive movement in the share price based on the 14-day RSI (39.38). BATS shares have generated a return of around 8.86% over the last one month, whereas FTSE-100 has generated a return of about 14.54%.

In the last ten years, British American Tobacco Plc share price has delivered around 13.19% return as compared to the approximately 10.83% return of FTSE 100 index, which shows that the stock has outperformed the index during the last ten years.

Valuation Methodology: Price/Earnings Approach (NTM) (Illustrative)

Business Outlook Scenario

British American Tobacco delivered growth in sales in H1 FY20, with an increase in earnings and cash flow from operations. The Company had a resilient operating cash conversion in the first half of the financial year. The Company believes that the non-combustible segment will drive the revenue and it has invested an additional £250 million in New Categories marketing.  In FY20, the Company expects the revenue to decline by around 1.3% on constant currency due to the pandemic headwinds. The constant currency adjusted diluted EPS growth is expected to be in mid-single digit. The operating cash conversion is expected to be more than 90%. The Company expects the underlying tax rate to be slightly lower than 25%, which was the previous guidance. The foreign exchange translation is expected to bring down the full year adjusted earnings per share growth by 2.5%.

The Company is making progress towards the goal of achieving £5 billion revenue in the New Category segment by 2025. The acquisition of Dryft Modern Oral business has helped the Company to expand its modern oral portfolio from four to 28 product variants. The Company has challenged the sales ban in South Africa, which is expected to have an impact of £25 million per month on adjusted profit from operations. In 2020, the global travel business for tobacco business underperformed and it is expected to remain subdued for the remainder of 2020. In H2 FY20, the income from its associate in India, ITC, would be low due to the impact of the pandemic.

(Source: Company website)

Considering the good fundamental performance in H1 FY20, robust liquidity position, targeted mid-single figure growth in adjusted diluted EPS, decent business growth rate trajectory, stronger consumption trends, sound business model, the strength of the differentiated brand portfolio, improved profitability margins, and support from the valuation as done using the above method, we have given a “BUY” recommendation on British American Tobacco at the current market price of GBX 2,649.00 (as on 30 November 2020, before the market close at 8:02 AM GMT) with lower double-digit upside potential based on 9.86x Price/NTM Earnings (approx.) on FY20E earnings per share (approx.).

*All forecasted figures and Peer information have been taken from Refinitiv, Thomson Reuters.

*Dividend Yield may vary as per the stock price movement.

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