British American Tobacco: Mixed H1, But Attractive At 8.0% Dividend Yield
Summary
- H1 results showed strong headlines, but a mixed underlying performance, in line with the low expectations in our investment case.
- EPS growth was 6.1% in H1 and is guided to be mid-single-digits for 2021 excluding currency, which is likely neutral for U.S. investors.
- H1 EBIT growth was led by strong cigarette price/mix in the U.S.; other regions saw either low-single-digit EBIT growth or a decline.
- In New Categories, BAT had aggressive price promotions, but remains a distant #2 in Heat Not Burn and U.S. nicotine pouches.
- With shares at 2,680.5p, we expect a total return of 69% (19.1% annualized) in just under 3.5 years. The Dividend Yield is 8.0%.
Introduction
We review our British American Tobacco (NYSE:BTI) (referred here as "BAT") investment case with H1 2021 results released last Wednesday (July 28).
We upgraded our rating on BAT to Buy in March 2020. Since then, shares have gained 15.9% (including dividends) in GBP, which has appreciated by 21% against USD. BAT's share price has significantly underperformed peers:
| BAT Share Price vs. Tobacco Peers (Since 22-Mar-20)
Source: Yahoo Finance (02-Aug-21). |
We see BAT's H1 as mixed but in line with the low expectations in our investment case. Our forecasts show a 69% total return (19.1% annualised) by 2024 year-end, including a Dividend Yield of 8.0%.
Buy Case Recap
Our BAT investment case has the following components:
- A broadly stable cigarette business in the U.S., where E-vapor is the main threat but only growing moderately (led by BAT)
- Non-U.S. cigarette markets to be mostly stable, except disrupted by IQOS heat-not-burn, but with only limited impact on group earnings
- A low-single-digit EPS decline in 2021, due to COVID-19 and currency
- A mid-single-digit EPS CAGR from 2022, thanks to broadly stable cigarette revenues, expanding margins and a future resumption of buybacks
- A re-rating of its P/E multiples upwards to 10x (from approx. 8x)
We expect relatively low earnings growth because we believe BAT's Next Generation Products ("NGPs") will remain far behind the leader in most markets, except in E-vapor which has so far struggled with profitability.
Together, a low-single-digit EPS CAGR in 2020-24, a 25% re-rating in 4 years and an 8.0% Dividend Yield should give a high-teens annualized return.
As a reminder, the U.S. has contributed half of BAT's segmental Profit from Operations ("PfO", equivalent to EBIT) and most of its PfO growth since 2017; non-U.S. PfO has been roughly flat (in GBP):
| BAT PfO by Region
Key: EEMEA = Eastern Europe, Middle East & Africa; ENA = Europe & North Africa; AMSSA = Americas & Sub-Saharan Africa; APME = Asia-Pacific & Middle East. Source: BAT company filings. |
H1 2021 results are in line with our views.
Strong H1 Headlines and Full-Year Outlook
For H1 2021, excluding currency, BAT reported year-on-year growth of 8.1% in Net Revenues, 5.4% in Adjusted EBIT ("Profit from Operations" at BAT) and 6.1% in Adjusted EPS; including currency, Adjusted EPS fell 2.3% in GBP:
| BAT Profit & Loss (H1 2021)
Source: BAT results release (H1 2021). |
Translational currency headwinds subtracted approx. 8 ppt from EBIT and EPS (transactional currency headwinds were 2 ppt and not adjusted out). We estimate approx. 5 ppt to be from the GBP/USD rate rising 10%, less relevant for non-U.K. investors:
| GBP Rates for Key BAT Currencies (H1 2021 vs. Prior Periods)
Source: BAT results release (H1 2021). |
While the depreciation of Emerging Markets ("EM") currencies is ongoing and likely permanent, only 25% of BAT revenues are EM.
For 2021, BAT reiterated the same outlook from June, with constant-currency growth of more than 5% in revenues and mid-single-digit in Adjusted EPS:
| BAT 2021 Outlook
Source: BAT results presentation (H1 2021). |
In GBP, including an expected currency headwind of 7%, Adjusted EPS is expected to shrink by 2% in 2021; with GBP/USD now approx. 8% higher than the 2020 average (1.39 vs. 1.28), there is little currency headwind in USD.
The outlook assumes some improvement in EM but no recovery in Travel Retail; it includes a £170m one-off hit from an excise change in Australia. The amount of savings expected from the Quantum efficiency program by the end of 2022 has been increased from £1.0bn to £1.5bn.
While both H1 results and full-year outlook are strong, the underlying performance is more mixed, especially in NGPs.
Mixed Performance Outside the U.S.
BAT's 5.4% year-on-year PfO growth in H1 (in constant currency) was primarily driven by a 9.7% growth in the U.S.; PfO grew by less than 5% in APME (Asia-Pacific & Middle East) and AMSSA (Americas & Sub-Saharan Africa), and actually fell by 3.7% in ENA (Europe & North Africa):
| BAT Volume, Net Revenues & PfO (H1 2021 vs. Prior Periods)
Source: BAT company filings. |
BAT's cigarettes business is strong in the U.S. but is mixed elsewhere:
In the U.S., most of the revenue growth (£394m out of £511m) was led by an 8.1% growth in Combustibles revenues, driven by a 12.3% price/mix.
In APME, revenues only partially recovered from the COVID-driven decline last year; PfO only grew 2.8%, compared to a 6.9% prior-year decline. PfO margin fell 110 bps due to a negative mix shift to lower-margin markets and an excise increase in Japan.
In AMSSA, revenues grew 11.4% after 0.9% prior-year decline, but PfO only rose 4.2% after falling 3.6% last year. PfO margin fell 270 bps due to a negative mix shift in consumables and higher "investments" in Vapour.
In ENA, PfO fell 3.7%. Total revenues rose 5.9% only due to NGPs; Combustibles revenues fell1.2%. The PfO decline was attributed to negative mix from, and higher "investments", in NGPs.
Weak Non-U.S. In Contrast with Philip Morris
BAT's weak performance outside the U.S. is likely structural, because it came after an already-weak prior year, and because of the strong growth in the same regions achieved by Philip Morris (PM):
| Philip Morris Volume, Net Revenues & EBIT (H1 2021 vs. Prior Periods)
Source: PM company filings. |
Whereas BAT's PfO declined in ENA in H1 2021, Philip Morris had double-digit EBIT growth in the European Union, Eastern Europe and Middle East & Africa, after double-digit growth in the first two regions in H1 2020.
Whereas BAT's PfO only grew by 2.8% in APME, Philip Morris's combined EBIT in Asia, Middle East & Africa grew 11.3% year-on-year.
Whereas BAT's PfO only grew by 4.2% in AMSSA, Philip Morris's EBIT grew by 9.5% in LAMAM & Canada and 15.0% in Middle East & Africa.
Next Generation Products Growth Is Costly
One of BAT's key messages in its H1 results was "new category acceleration". NGP revenues grew 50% year-on-year (excluding currency):
| BAT Next Generation Products Revenues
Source: BAT company filings. |
On a sequential basis and measured in GBP, growth was more moderate - with Tobacco Heated Products ("THP") revenues up just 3% and non-U.S. Modern Oral revenues apparently flat; U.S. Modern Oral revenues were just £8m.
THP revenues in APME actually fell 3.5% year-on-year (excluding currency), despite volume rising 23%, after BAT choose to partially absorb an excise hike.
BAT's NGP business is loss-making in aggregate and only targeting profitability by 2025. Management expects losses to be shrink in 2021, though they grew in H1 after £350m of incremental investment.
Few of BAT's NGP businesses are profitable individually - just THP in Japan and Modern Oral in "most" markets (likely not the U.S.). Management is predicting Vapour will be profitable "in places like Canada" "very soon".
Aggressive New Categories Price Promotions
BAT's NGP growth has been achieved with aggressive price promotions.
In the U.S., Vapor revenue growth of 56% was achieved with volume growth of 97%, while Modern Oral revenue growth of 29% was achieved with volume growth of 450%, both implying large price reductions:
| BAT U.S. New Categories Volume and Revenue
Source: BAT results release (H1 2021). |
According to Swedish Match (OTC:SWMAF), in Q1 2021 the average price for BAT Modern Oral products in the U.S. was half that of Swedish Match's ZYN, and also nearly 20% cheaper than Altria's (MO) On!.
In THP, in Japan, BAT chose not to recover part of the excise increase through price. Across its top 5 THP markets (which were 85% of volume), BAT consumables were priced on average 10% cheaper than Philip Morris.
Price promotions contributed to BAT's NGP losses and, in our view, have only a limited impact that will fade over time.
Outside Modern Oral in the Nordic and (loss-making) Vapour, BAT's share in NGPs is significantly less than its share in cigarettes, which was 28.8% globally and 34.6% in the U.S. in 2019 (by volume). Until BAT closes the gap, smokers moving to NGPs will on average be negative for its value share.
Heated Tobacco: Still a Distant #2
In THP, the largest New Category by industry profits, BAT was outpaced by Philip Morris by a factor of 7 in dollar revenue growth ($149m vs. $1.06bn) in H1, though its percentage revenue growth is 4 ppt higher:
| Volume & Revenue Growth - BAT vs. PM (H1 2021)
Source: Company filings. |
BAT's volume growth is much higher, due to aggressive price promotions. However, even when measured in volume, BAT remained a distant #2 in key THP markets, albeit improving in the last few quarters:
| BAT THP Volume Share in Selected Markets
Source: BAT results presentation (H1 2021). |
BAT's relative volume share gain in THP has not prevented Philip Morris from growing its Heated Tobacco Units' ("HTU") share of the tobacco market in the same countries, for example gaining 3.5 ppt to reach 11.2% in Italy:
| PM HTU Market Share & Volume in Key Markets (Q2 2021 vs. Prior Periods)
Source: PM results release (Q2 2021). |
In Japan, IQOS' first breakout market, Philip Morris again increased the market share of its HTUs and of its tobacco products as a whole; it did the same in Italy. Total volume shares fell slightly in Russia and Poland, but this could happen in the early stages of a NGP (which tends to covert one's own smokers first), and Eastern Europe EBIT was up 23.4% in H1
U.S. Nicotine Pouches: Growth Stalled in Q2
After consumer promotion in March, BAT's volume share in U.S. nicotine pouches fell in Q2 to 13.5%, compared to Swedish Match's 63.8%:
| BAT U.S. Nicotine Pouches Volume Share
Source: BAT results presentation (H1 2021). |
Industry figures shared by Swedish Match indicate that BAT's Velo/Dryft saw little volume growth in Q2, sharply underperforming ZYN and On!:
| U.S. Nicotine Pouches Volume & Market Share
Source: SWMA results presentation (Q2 2021); annotations by Librarian Capital. |
When questioned about this share loss, BAT 's response mentioned that Modern Oral is only 1.6% of the U.S. nicotine market (by value). While this is correct, this was a sharp increase from the 1.0% figure in 2019.
Wins in Vapour and Nordic Modern Oral
On the positive side, BAT has continued to grow in Vapour, with its value share exceeding 30% in the U.S. in Q2; it is also leading in U.K. and France:
| Vuse Value Share in Selected Markets
Source: BAT results presentation (H1 2021). |
BAT's gain is likely to have come at the expense of Juul, which lost 9 ppt of volume share and about 10% of its volume year-on-year as of Q2 2021:
| Juul Volume Share in U.S. Vapour
Source: Altria results supplement (Q2 2021). |
Volume growth in U.S. Vapour has been moderate in recent quarters; this is consistent with the strong cigarette price/mix achieved by both BAT and Altria:
| U.S. Vapour Industry Volume
|
BAT's Velo remains the volume leader in Modern Oral in Nordic markets:
| Velo Volume Share in Nordic Markets
Source: BAT results presentation (H1 2021). |
However, total Modern Oral revenues in ENA were just £115m in H1 2021, or 2.1% of the group. Its growth will not be a material driver for BAT earnings.
Is BAT Stock Expensive?
At 2,680.5pp, BAT stock is trading at an 8.1x P/E and an 11.9% Free Cash Flow Yield:
| BAT Net Income, Cashflow & Valuation (2018-20)
Source: BAT company filings. |
The annual dividend is 215.6p (paid in 4 equal quarterly payments), representing a Dividend Yield of 8.0%. The target Payout Ratio is 65%.
Net Debt / EBITDA is expected to reach around 3x at 2021 year-end, after which we believe buybacks will resume.
BAT Stock Forecasts
We keep our forecasts unchanged from June (see our article for the list of assumptions):
| Illustrative BAT Return Forecasts
Source: Librarian Capital estimates. |
With shares at 2,680.5p, we expect a total return of 69% (19.1% annualized) by 2024 year-end, in just under 3.5 years.
Is BAT Stock A Good Buy? Conclusion
H1 results are in line with the low expectations in our investment case.
We reiterate our Buy rating on BAT.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BTI,PM,MO,SWMA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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