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Morningstar | British American Tobacco Appears on Track in Preclose Trading Update

We are retaining our short-term estimates, wide economic moat rating, and GBX 4,500 fair value estimate for British American Tobacco following the company's brief trading update before it closes the books on 2018. Management said it expects BAT to beat its full-year high-single-digit EPS growth guidance. More significant to the company's valuation, in our view, is the potential ban on menthol in the U.S., which could significantly reduce sales of the company's Newport brand.

BAT says it expects an industry decline of 3.5%, but that it will take share of around 40 basis points. While the industry decline is slightly faster than in previous years, in part due to the growth of vaping in the U.S., this is in line with our expectations. Price/mix above the 5.5% achieved last year is encouraging, however, and although it probably contributed to the volume declines, shows that price elasticity remains in the normal range.

Currency will be a headwind of around 6% in the full year. This is likely to reverse next year, however, if sterling remains at current levels. We believe BAT and the broader tobacco group would behave relatively defensively in the event of a disorderly Brexit. Low price elasticity in tobacco consumption has historically led to sales growth remaining comparatively robust during previous economic recessions.

Our estimate of net debt/EBITDA of 3.6 times may prove to be too optimistic. Management expects the ratio to be around 3.9 times at the end of the year, which could imply risk to our EPS forecast through higher interest expense. This is above previous guidance of 3.3-3.5 times. Deleveraging must be an immediate priority for BAT, and with heightened menthol risk likely to linger for at least two years, we expect dividend growth to slow to a low- to mid-single-digit rate for the foreseeable future.