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The company continues to benefit from its acquisition of Reynolds American, which has expanded its presence in high-growth emerging markets and in the U.S. The acquisition should also help BTI to strengthen its R&D program and expand its share in the smokeless market. British American faces a range of legal and regulatory risks, including smoking bans, restrictions on package advertising, and risks related to allegations of bribery in its African operations. It also faces competitive challenges, both from established cigarette companies and manufacturers of smokeless products, as well as pressure from rising taxes and sales of counterfeit cigarettes. The stock has recently faced pressure from concerns about stronger FDA regulation of both smokeless and smokeable products, and the reduction of nicotine in these products to non-addictive levels. We think the shares offer value, though, as well as a high dividend yield. $40, reduced from $50 to reflect ongoing industry risks.

RECENT DEVELOPMENTS

The beta on BTI is 0.6. The company reports twice a year and presents its results in British pounds. British American Tobacco also provides a pre-close trading update ahead of its results. For the convenience of U.S. ADR investors, we provide dollar-based EPS and dividend estimates. Each ADR represents one share of common stock. On July 31, BTI reported the first-half results. Revenue was GBP 12.3 million, up 0.8% from what it was in 2019. Profit from operations rose 3% on an adjusted basis as they widened by 43.7%. Adjusted diluted EPS increased 6.6% to 157.8 pence. In U.S. dollars, at the average 1H exchange rate of 1 GBP/$1.25, 0.97 per ADR. For the full year, the company currently expects constant-currency adjusted revenue growth of 1%-3%, reflecting a 3% revenue headwind from COVID-19 and expectations for a continued global recovery in the second half. For the medium term, management projects 3%-5% constant-currency adjusted revenue growth and high single-digit constant-currency adjusted EPS growth. U.S. industry volume was 2.5% in 2020, better than the previous forecast of a 4% decline, reflecting resilient consumer demand. The company relies in part on new products to generate growth. On November 28, it announced three new brands in its ‘New Categories’ segment: VUSE for vapor products, VELO for modern oral products, and glo for tobacco heating products.

EARNINGS & GROWTH ANALYSIS

The company has three main product segments: Combustibles (88% of 1H20 revenue), New Categories (5%), and Traditional Oral (5%). It also has four geographic segments: the U.S. (46% of first-half revenue); Americas and Sub-Saharan Africa (AmSSA) (14%); Europe and North Africa (ENA) (23%); and Asia-Pacific and Middle East (APME) (17%). In addition, the company has a ‘strategic portfolio’ consisting of its ‘global drive brands’ (Kent, Dunhill, Lucky Strike, Pall Mall and Rothmans); three U.S. brands (Camel, Newport and Natural American Spirit); and reduced-risk products. Total 1H revenue growth was helped by 6% constant-currency growth in the strategic portfolio. In the Combustibles segment, volume declined 6.5% in the first six months of 2020, reflecting supply-chain disruptions in certain markets, partly offset by more favorable pricing and product mix. The New Categories segment includes Vapor, Tobacco Heating Products (THP), and Modern Oral. Vapor volume was up 43% from 2019, reflecting strength in the U.S. THP volume rose 9.1%, driven by the growth of glo Pro and the launch of glo Hyper (a new THP device) in Japan, Russia, Italy, Romania, and Germany.

Modern Oral volume increased 74%, reflecting strong sales of Velo (nicotine pouches produced by BTI) in the U.S. Velo achieved a category volume share of 9% for the six months that ended in June 30, 2020, as distribution expanded to more than 120,000 outlets. In 1H, the adjusted operating margin widened by 40 basis points to 43.7%, reflecting savings from the company’s Project Quantum program. The program focuses on efficiency gains and has enabled the company to spend more on New Categories marketing without substantially increasing total expenses. Trends and expenses and current earnings are at 0.25 per ADR from $4.15.

FINANCIAL STRENGTH & DIVIDEND

The debt/cap ratio was 73% as at June 30, 2020, above the 10-year historical average of 60.7%. Management has said it is committed to the dividend and expects to pay out 65% of adjusted EPS on an annual basis. 208.6p ($2.61) for 2020 and 215p ($2.69) for 2021. The company has suspended its share buyback program due to its investment in Reynolds American.

MANAGEMENT & RISKS

Jack Bowles, formerly the company’s COO, took over as CEO from Nicandro Durante on April 1, 2019. The finance director is Tadeu Marroco. British American has expanded its business through a range of investments, including the acquisition of the remainder of Reynolds American. In 2015, it spent $4.7 billion to maintain a 42% stake in an enlarged Reynolds American, paid 1.7 billion pounds to acquire the shares of Brazilian tobacco company Souza Cruz S.A. that it did not already own, and acquired Croatian tobacco company TDR for 550 million euros. It also purchased CHIC, a Polish e-cigarette business. On December 21, 2017, the company agreed to acquire 100% of Twisp Propriety Ltd., a South African e-cigarette/nicotine vapor company. The company’s three key priorities are: driving value from Combustibles, ensuring a step change in New Categories, and simplifying the business. British American Tobacco faces a range of legal and regulatory risks, including smoking bans, restrictions on package advertising, and risks related to allegations of bribery in its African operations. It also faces competitive challenges, both from established cigarette companies and manufacturers of smokeless products, as well as pressure from rising taxes and sales of counterfeit cigarettes. The stock has recently faced pressure from concerns about stronger FDA regulation of both smokeless and smokeable products, and the reduction of nicotine in these products to non-addictive levels.

COMPANY DESCRIPTION

London-based British American Tobacco plc. is the holding company for a group of companies that manufacture, market and sell cigarettes and other tobacco products, as well as smokeless products. The company has approximately 64,000 employees, not including employees working at tobacco farms. Its major brands include Newport, Dunhill, Kent, Lucky Strike, Pall Mall, Vuse, Rothmans, Vogue, Viceroy, Kool, Peter Stuyvesant, Benson & Hedges, John Player Gold Leaf, State Express 555, and Shuang Xi.

VALUATION

We think the shares offer value as well as a high dividend yield. We are reaffirming our BUY rating with a revised target price of $40, reduced from $50 to reflect ongoing industry risks.


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