Huff and puff all you like, you won’t blow BAT down


Huff and puff all you like, you won’t blow BAT down

Peer through the investment smoke surrounding British American Tobacco and you'll see it’s a screaming buy

Tim Cohen

There are plenty of investment conundrums on the JSE at the moment, but perhaps one of the largest is British American Tobacco (BAT).
The conundrum is this: the share is cheap as chips, the company is earning a fortune, it’s growing at a respectable pace, but the share price just doesn’t seem to be able to generate any momentum. Any value metrics you care to apply, the company comes out as a screaming buy. Yet the share price has just been slaughtered in 2018: down by almost half over the past year, and down 36% over the last three months.
What happened to the idea of the cigarette company as the ultimate “safe harbour in choppy waters” defensive stock? Smoking is bad for your health; everybody knows this now, and consequently cigarette companies are on nobody’s “responsible investing” list. Nicotine is an addictive poison. But then again, if you are anything like me, so is cheese, salami, Scotch, wines from Kanonkop and Lindt chocolate, just to name a few. Anyway, let’s just assume you have no qualms about investing in tobacco.
Despite an absolute barrage of government intervention to reduce smoking over the past two decades, cigarette companies have continued to do well financially – extremely well. Better, oddly enough, than before the implementation of smoking bans, the bold warnings on cigarette packets, and the ridiculous laws about smoking close to office doorways. For years, tobacco companies were getting their growth from places in the world where these laws were not yet applicable, mainly in developing countries.
But that growth has all pretty much been saturated now and, despite the public awareness campaigns, smoking levels have more or less plateaued in many developed countries around the world at about 20% of the population. That’s an awful lot of people still smoking. And the public awareness campaigns have had some perverse consequences, which is so often the result of aggressive government intervention. Around the world, the restrictions had the effect of closing out competition, solidifying the position of the existing players.
SA, by the way, was following the global pattern very closely until recently when Sars was deliberately undermined by former president Jacob Zuma and the general collapse of law and order. New tobacco companies have flooded the market with illicit products. SA cigarettes are now among the cheapest in the world, completely undermining the public health campaign.
But for BAT, the global restrictions have, ironically, been much less of a disaster than you might imagine. What really astounds me about BAT is its level of profit; in 2016, for example, gross profit was £10.6bn and operating profit was just under £5bn.
Just as one measure, the largest company by revenue in the US, Walmart, made £7.7bn in 2017. The average profit of a Fortune 500 company is £600m. BAT had a return on equity of about 50% over the past few years. Compare that to the average return on equity of a Fortune 500 company – at 14.1%. This is a very profitable company, which is one of the reasons why it’s sitting on a very modest forward price to equity ratio of about nine times.
So how is it possible that a company – under strenuous attack from governments and health professionals, which is losing customers and which is being taxed to the gills – grow its profits?
The short answer is that it has been very tricky, but somehow the company has managed against the odds. One thing the company has going for it is that making cigarettes is very cheap. It costs somewhere between R2.50 and R4 to make a pack of smokes, which then goes on to sell for anything between R5 (if you are an illicit player) and about R40 if you are stupid enough to pay the government excise tax, which BAT does. SA’s entire bill for detective services is paid for by smoking taxes. There is one other thing BAT has been able to do. UCT academic Corne van Welbeek has done some very intensive, long-term research into the incidence of smoking in SA and the different levers that affect smoking. One of his lines of research has been the per-packet profitability of cigarettes, and interestingly, as excise duties started going up in real terms in 1994, so too did per-pack profitability. In other words, cigarette companies have been able to sneak in price rises every time excise taxes increase, which has basically been every year because the government would naturally take the blame for the increase. And, with a tighter market, they developed pricing power.
BAT has also been able to grow through incremental add-on acquisitions. The most recent calamity for BAT has been the decision in the US to restrict menthol cigarettes, which really knocks BAT because its menthol brand Newport is huge in the US. In fact, BAT bought out other shareholders of US-based Reynolds in 2016 for a thumping $47bn precisely because Reynolds had a big stake in Newport. It did so at a pretty high valuation, which has added to the subsequent valuation pressure on BAT itself, which has underperformed its big international rival, Philip Morris.
Another reason why it increased its stake in Reynolds is that the US company apparently had better “vaping” products, which were theoretically the new growth market for tobacco companies. But BAT recently said that revenue from so-called next-generation products are under pressure, which Philip Morris also indicated earlier in 2018.
So, back to the investment conundrum: is BAT a screaming buy? Financial analysts certainly seem to think so: 15 analysts who follow the stock rate it “outperform” or “buy”, as opposed to only three who rate it “underperform” or “sell”. Normally there is a “buy” bias in analyst recommendations, but this is much more definitive than normal. And you can see why: on paper, everything points to a cheap, cash-producing company. It has a 7% dividend yield, for heaven’s sake.
Personally, I just don’t see the growth drivers, but back in 2000 when the smoking bans were starting, everybody was saying precisely that, and history turned out differently, as it often does.

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