Interactive Investor

Stockwatch: is this 7% yield enough to tempt income investors?

13th December 2022 12:11

Edmond Jackson from interactive investor

This FTSE 100 firm is up almost 20% for the year versus circa 1% for the index, but it has a wall of investor worries to climb. Analyst Edmond Jackson considers prospects.

Was the 2022 re-rating of British American Tobacco (LSE:BATS) chiefly a macro event – with portfolios re-allocating from “growth” to “value” stocks – or could company fundamentals explain it?

Around 3,275p, the FTSE 100 stock is up 20% for the year versus barely 1% for the index, although BAT’s gain was 33% at June’s 3,625p high, as if something has changed in sentiment at least.

The group is known for brands such as Dunhill, Kent and Lucky Strike, and has become a global leader in vaping, with Vuse enjoying a 36% share in key markets. That puts BAT in relatively good stead as vaping takes over from cigarettes.

A second-half 2022 pre-close update is pitched as “accelerating our A Better Tomorrow transformation, at pace”, but I question whether it supports a rosy consensus for 2022 and 2023 numbers.

My “buy” stance at around 2,800p a year ago anticipated single-figure revenue growth improving to mid single-digit earnings growth from cost-cutting and price increases. Long-term operating margins near 40% imply an ability to cope with input price inflation.

My key argument, however, was anticipation of portfolios re-allocating from “growth” stocks to classic “value” – low price/earnings (PE) and an attractive yield – amid a sea change in expectations for interest rates.

I preferred BAT to Imperial Brands (LSE:IMB) but noted a legacy of £42 billion net debt – due to the 2017 acquisition of Reynolds – relative to £63 billion net assets, swollen by £114 billion intangibles. If interest rates were to stay higher for longer, interest charges could weigh.

A shift to “value” happened swiftly and BAT’s two-year chart nicely captures its December 2021 to June 2022 re-rating, with sideways, even slightly downwards trading before and after.

The all-time chart does, however, offer encouragement, with the stock having mean-reverted down after a long bull run from around 600p in 2000 near 5,500p in mid-2017.

Is the full-year 2022 prospect genuinely in line with expectations?

“Revenue growth of 2-4% at constant currency” compares with recent consensus for more than 9% growth to £28.0 billion, but given that 43% of interim revenue was US-derived, perhaps dollar strength may imply 5% or better for the year as a whole.

Interim revenue had been 3.7% at constant currency, albeit 5.7% reported, and the differential between US reported and constant currency revenue was £5.9 billion (equivalent) versus £5.5 billion.

Personally then, I do not expect 9% annual growth.

“Mid single-digit growth in adjusted diluted earnings per share (EPS), at constant currency” similarly compares with consensus for nearly 14% this year and 10% in 2023.

Leverage is guided at the high end of 2-3x adjusted net debt to adjusted EBITDA, with “net costs above £1.6 billion, driven by rising interest rates and dollar strength”. Interims had shown an 8% rise in the net finance cost to £817 million, covered 4.5x by operating profit.

More positively, a three year cost-cutting programme should deliver £1.5 billion annualised savings, relative to circa £10 billion historic operating profit.

Global tobacco volumes are predicted to ease 2% this year, and in the US “industry volumes will reflect increasing macro-economic pressures observed in the second half of 2022”. To help offset this, BAT says its “value” brands are benefiting from down-trading.

In vaping, Vuse has extended its global lead by 2.2% to 35.7% in the first nine months of 2022, and in the US, by 6.8% to 39.3%. Recently launched “Vuse Go” has reached second position in the UK and France value segment and is available in 12 countries.

They have helped BAT’s vaping and e-cigarettes add 3.2 million consumers over nine months to end-September, reaching 21.5 million. Profitability is targeted by 2025.

Mind how recession could affect tobacco demand before vaping profits kick in; and one should be aware of a growing backlash against younger people vaping.

British American Tobacco - financial summary
Year-end 31 Dec

 2015201620172018201920202021
Turnover (£ million)13,10414,13019,56424,49225,87725,77625,684
Operating margin (%)34.032.215138.234.838.139.8
Operating profit (£m)4,4534,55429,5479,35890169,82010,234
Net profit (£m)4,2904,64837,4856,0325,7046,4006,801
Reported earnings/share (p)2302491,360260247273289
Normalised earnings/share (p)234239251284316328326
Operating cashflow/share (p)253247261449393426423
Capital expenditure/share (p)32.336.147.741.135.632.932.4
Free cashflow/share (p)221211213408357394391
Dividend/share (p)154169100195203210216
Covered by earnings (x)1.51.513.61.31.21.31.3
Return on total capital (%)19.816.323.67.27.48.08.4
Net Debt (£m)15,00317,27645,64944,25942,24340,08835,933
Net assets per share (p)2634392,6492,8532,7862,7322,924

Source: historic company REFS and company accounts

EU vaping levy, and will a menthol ban spread in the US?

A European Union (EU) levy is mooted as part of a tobacco industry taxation review that would also double excise duties in member states with low cigarette taxes.

It implies the EU’s minimum excise duty on cigarettes would increase from €1.80 (£1.50) to €3.60 (£3) for a pack of 20, raising prices in Eastern Europe where packs can sell for less than €3.

Vaping products would be taxed in line with cigarettes, with those at lower strength to face a 20% duty and stronger ones at least 40%. Heated tobacco will be hit with 55%. This coincides with disposable incomes under pressure.

Meanwhile, in the US, a November vote in California showed 76.5% public support for a ban on flavoured tobacco products including menthol. The state of Massachusetts has already introduced a ban, with the bar taking effect in California from 1 January 2023.

It is pertinent given that BAT spent around $50 billion (£40.6 billion) in 2017 buying Reynolds, the manufacturer of Newport, the US’s leading menthol cigarette brand. Menthol accounts for more than half of BAT’s US cigarette sales and around 30% of its global profits.

Politically in the US, healthcare objections to smoking tend to be Democrat-driven, while Republicans counter that a ban would mean lower tax revenues and denying people the right to choose.

US midterm elections resulted in Democrat control of the Senate, but quite whether that amounts to more than rejecting legislation sent over from the Republican-controlled House of Representatives remains to be seen.

A risk of more US states banning menthol is thus something to be aware of. Such cigarettes are outlawed in Brazil, Canada, Ethiopia, Turkey, Moldova, the EU and the UK.

Imperial Brands is not so exposed to flavoured cigarettes – nor vaping– hence its circa 7% yield twice covered by earnings may be less risky than BAT’s 7.5% with 1.6x cover, if menthol was to be banned more widely in the US.

Menthol-flavoured cigarettes have existed since 1924 and are used disproportionately by African-American smokers, 80% of whom buy menthol primarily.

In 2011, an advisory panel to the US Food and Drug Administration (FDA) concluded that public health would benefit from removing menthol cigarettes from the market, to which the industry countered that they are no riskier than regular cigarettes.

The FDA moved in late 2018 to declare its intent to outlaw menthol, tempering this to a restriction, but stepped back on grounds that it could not win against legal challenges.

Groups representing African Americans then litigated against the FDA in 2021, to force a ban, citing highly addictive qualities for menthol and also racial disparities. Thus, in 2021, the FDA resumed its intent to ban and proposed regulations that were published last April.

The industry continues to argue, with some saying a ban will push users to illicit products given that it is unrealistic to expect demand to vanish.

Can BAT climb a wall of worries?

It certainly did versus US litigation challenges, some 20 years ago. Yet a clear-cut bull case seems lacking.

Given its strengths of cash generation, the market therefore seems likely to continue pricing for yield, and indeed, circa 7%=plus will be seen by many as attractive for BAT’s risks. The stock may also gain support from ongoing buybacks.

JP Morgan retains “buy”, targeting 4,000p, while Jeffries is even more optimistic at 4,800p.

I lack Jeffries’ conviction and regard asset re-allocation as the chief driver of the first half-year re-rating. Best decide if BAT suits your objectives and ethics. Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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