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Morningstar | British American Tobacco Posts Slight Miss to Our Estimates But Upside Remains to Stock

British American Tobacco missed our estimates of first-half revenue and operating profit by just over 2%, but the fact that the company beat consensus with underlying revenue growth of less than 2%, and the market has reacted so favourably, shows how pessimistic expectations of tobacco industry performance have become. We are reiterating our GBP 48 fair value estimate and our wide moat rating, and we believe there is upside to BAT and to the other large cap tobacco manufacturers in our coverage. Our pick of the group is currently Imperial Tobacco because we feel the market is being particularly punitive to Imperial.

Organic revenue grew by 1.9% in the first half of the year, with a strong contribution from the newly-formed Asia-Pacific Middle East segment of 5.6% underlying growth. This is a strong performance given that BAT was still cycling some disruptive tax increases in the Gulf region. All other geographies except the U.S. posted low-single-digit growth, although ENA was disappointing at just 1.3%, and alongside currency movements, contributed to the miss against our forecasts. Adjusted net revenue in the U.S. was flat, which itself was a decent performance given that BAT recalled a vaping product and that market leader Altria reported a 1.1% decline in revenue over the same period.

Following the Reynolds acquisition and the launch of glo in several markets, BAT has a significant non-cigarette portfolio, and the company now breaks out volumes and revenues for its heated tobacco and vapour businesses. It sold 3.3 billion Neostiks in the first half of the year, of which around 3 billion were sold in Japan, giving BAT a share of the total tobacco market of 4.3%. Category growth has plateaued, however, and we think new products, particularly a disposable heated tobacco product, will be necessary to increase adoption. Vapour volumes grew by 16.5%, which is still healthy, but a slowdown from the near-triple-digit growth achieved over the last several years.

Our valuation is dependent upon margin expansion, and the adjusted EBIT margin expanded by 50 basis points in the first half of the year. This was mostly driven by synergies from the Reynolds acquisition--with BAT disclosing that it achieved $140 million of the planned $400 million in cost efficiencies from the deal. Going forward, operational efficiencies and operating leverage from the growth of the strategic brands will be important to achieving our steady state margin assumption of 43.7%. While it is possible that the growth of glo could provide a positive mix effect at the gross margin, we expect the customer acquisition cost to rise over the next few quarters, and this could mitigate the benefits of BAT's efforts on cost savings.