While I dislike the tobacco industry on ethical grounds, from a pure investment analysis standpoint it is worth noting May’s dip in share price of British American Tobacco (BATS) within the FTSE 100 index, from a peak around 3,250p to about 3,000p now.
Although a “heavy” share price which may deter some people, its value credentials look strong indeed and worthy of consideration by investors trying to navigate a way through the wider financial mayhem.
Company REFS cites the consensus expectation among brokers for about 10% earnings per share growth in 2012 also 2013; and after Panmure Gordon just recently met with BATS’s investor relations team it published a note anticipating high single-digit earnings per share growth through to 2015. While it is speculative to look so far out, examining the company’s profile offer good reasons to trust it. The shares are also supported by a prospective yield about 4.7%.
Meanwhile, modest valuations apply to the tobacco industry because it is seen as overall in slight steady decline. Despite the scope to extend the number of smokers in developing countries, greater health awareness in the developed world and ongoing high taxes during recessions are mitigating factors. Within this challenging environment however, BATS has distinguished itself for marketing skills and costs management, which translate into stable earnings growth and a high level of cash generation.
So the nub of the bull case is BATS being valued in line with market benchmarks for the tobacco industry yet being able to deliver relative outperformance.
Despite pressures on global tobacco-related sales last year, BATS’s global volumes slipped only 0.4% to 705 billion products sold while growing market share. The four global drive brands – dunhill-cigarette, kent-cigarette, Lucky Strike and pall-mall-cigarette – achieved 9% volume growth overall. With the help of price increases, organic revenue at constant rates of exchange grew by 7%, meanwhile after adverse exchange rates 2011 reported group revenue rose 3%.
Marketing skills appear the key: product innovations and formats that can truly appeal to consumers. Innovations are said to account for over 35% of global drive brands’ sales, with many more in the pipeline. For example to date: resealable packs and capsule technology that can deliver a specific flavour – such as menthol – into the cigarette, super-slim variants and ways to improve the freshness of the product. There was £166 million investment last year, while modest in context of £3.3 billion cash flow and BATS’s £58.5 billion market value, should continue to enhance the product mix.
The operating margin has also improved significantly, from 33.5% to 35.8% last year, as costs were tackled by rationalising the manufacturing base.
It all helped normalised earnings per share rise 11% to 194.6p, albeit some discrepancy from an 8% rise in basic earnings per share to 157.1p. Cash flow rose 3% and representing 86% of earnings it is possible to distribute a high proportion via dividends, enhance earnings per share through buybacks, and service quite high levels of debt for optimal gearing. Such factors combine usefully to enhance equity value. BATS has generated over £23 billion of free cash flow since 2000, with nearly 80% returned to shareholders either through dividends or buybacks.
Net finance costs of £460 million last year were covered over 10 times by £4.7 billion operating profit. About £750 million was spent last year, buying back shares, and this is set to continue to a value of £1.25 billion. The 2011 total dividend rose 11% to 126.5p – i.e. well covered by earnings amid modest investment demands – so the company can indeed be distributing a high proportion of profits/cash.
Panmure Gordon argues for a £35 price target, implying total shareholder return over 20% on a two-year view perhaps, which is as good as you are likely to get for a relatively secure risk/reward profile among equities currently. Plenty may do better, if only with hindsight.
To quibble on the marketing front: BATS has yet to crack the Chinese market, which could prove hard even in the long run due to a saying: “tobacco and the government are one and the same” – yet over 40% of the world’s 5.5 trillion cigarettes sold annually are in China. BATS’s Asia-Pacific performance still showed a useful rise in profit last year, however there were adverse factors too. This region represents just less than a third of group revenue and profit, the main contributor after EEMEA (Eastern Europe, Middle East and Africa) then Western Europe and the Americas.
Illicit trade is also a growing problem – now cited as the principal risk to the group while tobacco taxes increase yet people’s incomes are pressured, however scare stories of sudden deaths after smoking such cigarettes may also limit it.
First-quarter 2012 results showed revenue up 6% at constant rates of exchange albeit 4% at actual rates – exchange rates now having improved. While this does not initially look encouraging, targeted pricing growth of 4% to 5% should help enhance operating profits. Quite how far BATS can push prices in a tough retail environment remains to be seen however.
Conservative investors should also be aware, BATS’s net asset value is little over 400p a share and negative net tangible assets prevail – with intangibles near £12 billion on the end-December balance sheet versus £3.0 billion property/plant and £2.6 billion investments in associates. With nearly £2.2 billion cash, current assets only just exceeded current liabilities but the working capital situation looks manageable.
BATS is ultimately going to be valued for its cash flow and on this basis it is superb. The retreat in its shares therefore makes it useful to consider as an equity portfolio building block.