British American Tobacco – Flickers of optimism #BATS
It has been a torrid two years in which to be a BATS shareholder (latest share price £30.50, market cap £70 billion).
From a personal point of view, I mistimed my entry with an average purchase price of £44.63 starting from late 2017.
Dividends worth c. 240p per share have been paid out during my holding period, cushioning the blow a little. After taking them into account, my loss on a percentage basis so far is c. 30%.
I have been determined to carry on supporting the company with my small stake (currently 4% of my portfolio), until and unless its solvency becomes questionable, or there is some other critical shock.
Let’s consider the latest results for 2018 and the prospects for this tobacco giant.
The main figures to understand 2018’s results are as follows:
- Revenues £24.5 billion, after the large acquisition of Reynolds American
If Reynolds had been owned over the entire two-year period, then adjusted revenues would have fallen 2.3% (using current exchange rates) or risen 3.5% (at fixed exchange rates). I prefer to look at results using fixed exchange rates, so this 3.5% growth figure is what I would focus on.
- Operating Profit £9.3 billion
£9.3 billion is the reported figure. The adjusted figure that the company focuses on (£10.9 billion) is derived as follows (see page 47 of the preliminary announcement):
Whilst one could argue the reasonableness of the adjustments, I do believe that they give rise to figures that are more or less comparable between years.
I would also note that the first set of five adjustments this year (from “restructuring and integration costs” down to “other adjusting items”) are about half a billion pounds smaller than they were last year. This says to me that adjustments did not get out of control in 2018!
So on review, I think that the 4% gain in adjusted profit (from £10.5 billion to £10.9 billion) is a real gain in the underlying financial performance of the business, and has not been artificially created through adjustments.
- Borrowings £47.5 billion, net debt £44.4 billion.
In simple terms, the ratio of borrowings to operating profit comes in at 5.1x.
BATS makes an adjustment to net debt arising from the Reynolds acquisition, so that “adjusted net debt” is £43.4 billion, a little lower than the “official” net debt shown above.
Adjusted net debt to adjusted EBITDA reduces from 5.3x to 4.0x, primarily as a result of increased earnings but also from a small reduction in debt.
The group’s credit ratings remain stable and investment-grade according to both Moody’s (Baa2) and S&P (BBB+), and it aspires to convince Moody’s to upgrade it by one notch to Baa1 in the medium-term.
Where the Cash is Flowing
Let’s see what BATS did with its prodigious cash flows in 2018.
Firstly, £9.3 billion in operating profit translated to £12 billion in cash from operating activities. This was thanks to favourable working capital movements and the timing of payments in respect to historic lawsuits (my interpretation is that Reynolds had overpaid into the Master Settlement Agreement in 2017, so the “cost” incurred in 2018 was non-cash).
After dividend income from its investees and tax payments, the net cash generated from operating activities by BATS in 2018 was a very strong £10.3 billion (it’s difficult to compare this with the prior year, as Reynolds was not fully owned until July).
Investment spending requirements collapsed back to normal levels in 2018, so the investing cash outflow was a mere £1 billion.
This meant that the remaining £9.3 billion cash inflow could be allocated as follows:
- Interest payments £1.6 billion
- Borrowing repayment £3.5 billion (net)
- Dividends £4.4 billion
If we reflect on this for a moment, it’s clear that BATS could be reducing its debts a much faster pace, if it simply reduced its dividends. According to its own definition, it generated free cash flow (operating cash flow after capex, interest, and a few other small items) of £7.7 billion. Roughly speaking, this is the amount by which it could have reduced its debts, if it had paid no dividends.
The Year Ahead
Total volumes are in decline (down 3.5% in 2018), and we might expect this mild downtrend to continue in 2019.
Offsetting this, the pricing power enjoyed by BATS brands plus increased revenues from high-growth tobacco heating products (THPs) and vapour can help to boost the group’s adjusted revenues.
I also believe that overall global demand for tobacco will remain robust in the medium-term. While overall volumes declined, volumes in the highly-populated Asia-Pacific and Middle East region were up marginally.
One of the main threats to BATS volumes is the illicit tobacco trade, and this has been particularly active in Brazil and South Africa.
Consensus forecasts indicate revenue growth of 2.6% in 2019, followed by near-5% growth in 2020 and 2021.
Cost savings at Reynolds, synergies and efficiency gains might all help to boost earnings, too. EBIT is forecast to grow 9% in 2019 and then by about 6% in each of 2020 and 2021.
There are lots of changes at the top of the company to think about, but the key change involves a company insider (Jack Bowles) replacing the incumbent CEO (Nicandro Durante) after eight years in that position. It appears to be an orderly transition with a good candidate taking charge.
Regulatory threat – about 24 hours ago, the US FDA Commissioner Scott Gottlieb suddenly resigned, without any clear explanation. Free market groups had urged President Trump (who nominated Gottlieb for the position) to stop the FDA from hammering the e-cigarette industry. Gottlieb had also come out as an opponent of the continued use of menthol in cigarettes, a key element of the BATS portfolio in the USA.
This resignation would appear to reduce the imminent threat against menthol (which was likely to be several years away, even if Gottlieb had remained in position).
Summary – it has been difficult to hold this stock through the slide in the share price, but it has now rallied 30% from the January low and published good full-year results. As investors gain comfort with the new scale of the group following the Reynolds acquisition, and net debt gradually declines, I think confidence might continue to grow and the share price could reclaim some of its former glory.
In the meanwhile, investors get to enjoy a dividend yield of c. 7%. Seems like a fair deal to me!
At the time of publication, the author has a long position in BATS.