Money Never Sleeps

I recently attended a presentation by British American Tobacco (BAT), the second largest listed company on the JSE by market money tobaccocapitalisation (R551bn) after BHP Billiton. I can honestly say it was the best presentation I have attended in at least the past decade and came close to the seminal presentation given by then-SAB CEO Meyer Kahn (now chairman of SABMiller) in Braamfontein in the late 1990s.

What made this presentation so special, apart from the superb delivery of Head of Investor Relations Ralph Edmondson, was the fact that it was a global update on BAT’s activities, rather than just a bog standard results presentation. Edmondson kept the large audience on the edge of their seats and answered all questions with aplomb.
Although BAT is not a constituent of the JSE ALL-Share Index due to the fact that it is classified as an inward listing, it is an extremely widely held stock in South Africa. It is estimated that the South African share register contain 55 000 shareholders. And it’s not surprising that most shareholders like this stock as it has been a great dividend payer on the back of gradually improving earnings.

What is perhaps surprising for the uninitiated is that a tobacco company should be experiencing growing earnings while demand for its products is declining globally. Even more surprising has been its consistent out-performance of the FTSE-100 index (the Footsie) over the past five years. In the decade since 2000, total return to shareholders has averaged in excess of 20% per annum.

To understand why this is happening, it is necessary to “get under the skin” of what drives tobacco companies in this day and age. Firstly, some people think that tobacco is recession-proof. It’s not but it is recession resistant. What this means, effectively, is that cigarette smokers will do everything in their power to keep on smoking their favourite brands unless and until economic necessity forces them to either quit altogether or to switch to cheaper, sometimes smuggled brands. Smokers are exceptionally brand conscious and exceptionally brand loyal, so to keep a competitive edge, tobacco companies must maintain a diversified and balanced brand portfolio. In other words, they have to maintain a balance between premium, mid and low priced segments. Interestingly, BAT’s so-called “global drive brands”-Lucky Strike, Dunhill, Kent and Pall Mall-have maintained their strong growth trajectories despite the recession.

And while smoking in the developed world carries a certain amount of stigma, that is not necessarily the same in many developing countries. Hence tobacco companies generally mitigate their risk by having a wide geographical diversity. BAT’s top five markets are Canada, Brazil, South Africa, Russia and Australia-all commodity based economies with reasonably stable currencies. Collectively, they account for 40% of profits.

Take the Asia-Pacific region for example. Last year, volume grew by 2%, revenue rose by 15% and profit was up by 16%. And this, of course, doesn’t include China, the world’s biggest tobacco market, where the China National Tobacco Corporation (CNTC) enjoys a near-monopoly situation. But the rest of the Asia-pacific region is seen as a growth area by all of the major tobacco companies and hence they all put in a lot of marketing effort in this area.

At the other end of the spectrum, western Europe saw an 8% volume decline, a 12% drop in revenue but, thanks to significant margin improvements, a 6% rise in profits. Eastern Europe didn’t fare so well though, with a 3% volume decline and a 12% fall in profits. Smuggling of illicit cigarettes was a big factor here, especially in Romania. Africa and the middle east was the star performer; on a 2% volume decline, revenue rose by 11% and profit soared by 19%.

BAT’s basic business model is fairly straightforward. Typically, the group would expect to see 1 to 1.5% growth in volumes, which would translate into revenue growth of about 3 to % which in turn should result in profit growth of 6 to 7%. But even where things don’t go totally to plan, as they have in recent years with declining volumes, there is ample latitude to compensate. For example, in 2010, organic volume growth (before the impact of any acquisitions) was -3%. But, thanks to excise increases, revenue grew by 3%. “We like modest excise increases which can be anticipated by the consumer”, said Edmondson. This is a very important point and one which is not necessarily fully understood by the market. Someone in the audience asked why consumers didn’t baulk at excise increases to which Edmondson replied “what choice do they have?”. He’s right of course. The only real choices they have, as stated earlier, are to quit altogether (which many smokers invariably do, and regularly) or switch to cheaper or smuggled brands. Anyway, that 3% revenue growth translated into 6% profit growth and 15% earnings growth. Admittedly, the weak British pound played a big (approximately 5%) part in this, as BAT’s profits are measured in Sterling but nevertheless it’s not a bad performance in a year when volumes went backwards and demonstrates the resilience of tobacco companies.

Edmondson also demonstrated some of the innovations that have kept BAT ahead of their competitors in recent times. For example, its “Reloc” pack, which keeps cigarettes fresher after the pack has been opened, helped Dunhill to go from a tiny 2% market share in the Gulf states to almost 11% in a remarkably short period of time.
In Japan, menthol cigarettes are popular and BAT capitalised on this with its capsule technology. Basically this means that the cigarette contains a small menthol capsule in the filter tip which, when squeezed, releases a burst of menthol. It was introduced successfully in the Kent, Kool and Lucky Strike brands.

BAT sees potential for improving its operating profit margin from an already impressive 33.5% to 35% by next year. It believes that its cost base is too high and that this is the main reason its operating profit margin is well below that of its competitors. If recent history is anything to go by, it should be successful in this endeavour. Between 2003 and 2007, it achieved annualised cost savings of GBP1bn. By concentrating on shared services and smarter operating platforms, BAT reckons that 35% margin can be met by next financial year.

Whatever one’s views on the morality or otherwise of smoking, it is hard to deny that tobacco companies are great investments. They all generate huge cash flows, as there is only minimal capital expenditure required in their businesses. Balance sheets are usually in excellent shape and share buybacks and generous dividends are the order of the day.

One of the few negatives affecting tobacco companies is the incidence of smuggling of illicit products. In jurisdictions where this is acute, tobacco companies sometimes work together with governments to limit the impact. Excise duty derived from tobacco is a meaningful part of any government’s coffers so it makes sense for them to combat the illicit trade, which pays no taxes.

BAT recently demonstrated great innovation by flighting a series of radio advertisements suggesting that , by smoking smuggled cigarettes, smokers were indirectly and inadvertently helping to support many other nefarious activities such as gun-running and murder.

Even in environments where their activities are hamstrung by government legislation, such as advertising bans for example, tobacco companies still manage to get their products to those consumers who crave them. For as long as the craving persists, tobacco companies will thrive.

Posted in: British American Tobacco (BAT),cigarette smokers,tobacco companies