The multi-year challenge which the tobacco industry is facing remains in sharp focus, although British American Tobacco (LSE:BATS) is ahead of schedule in its switch towards New Category Products.
The important US market is showing some signs of frailty given broader macroeconomic pressures and, according to BAT, a proliferation of illicit modern disposable vapes which is having an impact on the combustibles market. There has also been some slowdown in the premium segment part of the market as consumers switch to cheaper brands, with a resultant drop of 0.1% in volume share.
Indeed, BAT has decided to reduce the intangible value of some of its acquired US combustible brands by some £25 billion, following a review of their likely value over the next 30 years. While this non-cash adjustment does not affect trading performance, it is nonetheless a stark reminder of the switch which needs to be made to different products as consumer tastes change and as regulation becomes a higher hurdle to jump.
In terms of its New Category Products, this update provides some welcome news in light of the pressure being felt elsewhere in the business. Its Velo brand now has an estimated market share of 67% in Europe, while the Vuse product saw a jump of 5% in its US market share to 46% and is now available across 59 markets.
Most promisingly, the loss-making division which had been the subject of high investment without revenues to match is expected to be broadly breakeven this year, some two years ahead of BAT’s target and as a likely precursor of things to come.
To that end, the strategic focus has now been set in stone, with the group aiming for 50% of overall revenues to come from non-combustibles by 2035, and with continued innovation and investment in new products remaining key to keeping BAT among the leaders in its chosen markets, both in terms of geography and product.
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In the meantime, BAT is maintaining its guidance of growth for this year of between 3% and 5%, albeit at the lower end of the range. The company’s prodigious cash generative ability is allowing a sharper focus on its net debt position, which for the moment remains a higher priority than shareholder returns in the form of share buyback programmes. That being said, the dividend seems to be under little pressure and the current yield of 9.3% is a standout attraction, particularly for income-seeking investors.
For the traditional products which still prop up the business overall, there are signs of ongoing resilience. The nature of the products allows for strong pricing power without destabilising demand, which offsets some of the issues the group is facing.
Even so, economic pressure generally and a post-Covid normalisation of habits has led to some downtrading, while finance costs have risen due to higher interest rates and the strength of the US dollar.
The tobacco sector in general has seen valuations decrease compared to historical levels and a reduced pool of potential investors, with some being unwilling or unable to enter the sector on ethical grounds.
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For BAT, this has resulted in a sharp drop in its share price, which has fallen by 27% over the last year compared to a marginal dip of 0.4% for the wider FTSE 100 index. The loss of the last two years is a rather more palatable 4%, but the lack of growth underlines the sector’s challenges, as evidenced by the major write-down of goodwill on some of its US combustible brands.
The market consensus of the shares as a 'buy' recognises the strength and potential of BAT’s cash generative abilities and prospects, although this general view inevitably falls into the category of a higher risk investment.
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