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Morningstar | British American Tobacco on Track With our Forecasts in Trading Update

We are retaining our short-term estimates, wide economic moat rating and GBP 45 fair value estimate for British American Tobacco following the company's brief trading update. The market has reacted negatively, with the stock trading down by almost 5% yesterday, but we do not believe the update revealed any incremental material negative information. We continue to believe there is significant upside to tobacco valuations, and following the steep sell-off in BAT this year, we are constructive on the stock.

We believe the three most significant items from BAT's update are: 1) next generation product sales (vaping and heated tobacco) are now expected to undershoot previous expectations, and the company is now guiding to GBP 900 million in revenue this year, down from the previous guidance of GBP 1 billion; 2) currency is weighing on reported performance, and net debt/EBITDA is not likely to fall to the previous guidance of 3.0 times by the end of 2019; and 3) the recent double-digit earnings growth trend remains intact in the short term.

If the downward revision of next generation product revenue had been because BAT was losing share, we would have been concerned, but the firm's heated tobacco share has edged upward in Japan over the course of the year, and now sits at over 4%, and the revenue miss will probably be to the benefit of revenue in the combustible business, which has been cannibalized by heated tobacco growth. We believe margins in next generation products are much lower than in combustible cigarettes, particularly in vaping, so a slower mix shift to the lower margin portfolio should be positive for EBIT and earnings growth, in our view.

BAT stated that net debt/EBITDA should be between 3.3 times and 3.5 times by the end of 2019. We had not modeled net debt/EBITDA falling to the previous guidance of 3.0 times, and we retain our estimates of net debt/EBITDA of just over 3.5 times.

We also retain our slightly below consensus estimate of GBP 2.64 in earnings per share this year. Commentary that the combustibles business remains healthy, with price/mix likely to be close to 6% this year is encouraging, and broadly in line with our assumptions. We do not assume, however, that BAT can sustain double-digit earnings growth for much longer, however, and we expect a slowdown in the outer years of our forecast period as lower-margin next generation products become a larger proportion of the portfolio mix, fewer efficiency opportunities arise, and interest rates rise.