Addicted to BAT

Politically correct investors, look away now. Investing in addiction is a proven way to make money, and a good way to do this is to buy shares in tobacco companies. The London market has two large tobacco groups, Imperial Tobacco and British American Tobacco (BAT), and shares of both the companies offer great defensive merits - most obviously, stable demand, strong cash flows and a hefty dividend yield.

That said, even tobacco groups have been hit by the consumer downturn. "We are resistant, but we are not immune," said Paul Adams, chief executive of BAT, after announcing his company's first-half results last week. Industry volumes have been under pressure, not necessarily because people are smoking less, but because, as excise increases made cigarettes more expensive, smokers turned to contraband goods. "Obviously, we don't compete in that market," Mr Adams said.

So, although the group saw overall volumes rise 5 per cent to 349bn cigarettes, its like-for-like volumes fell 2 per cent after stripping out the boost from the acquisition of Sweden's ST and Turkey's Tekel. But Mr Adams was unfazed by the trend, pointing out that most of the impact had been felt in BAT's lower-end business, and that its premium brands had continued to generate steady growth. Overall premium volumes - which account for a third of sales - fell 1 per cent against a 5 per cent fall in its low price cigarettes. And, in fact, BAT's so-called 'global drive' brands - Dunhill, Kent, Lucky Strike and Pall Mall - saw aggregate volumes rise by 5 per cent, as they continued to take extra share in most markets as smokers defected from rival brands. 

That's good news for BAT, because its premium brands are much more profitable. "The premium volumes are the ones you want to protect because that's where the money is," said Mr Adams. However, he was quick to add that, as part of its three-pronged plan for the recession, it's still important to have strong lowish-priced brands for those trading down.

The second component of the group's plan to power through the recession is innovation to encourage trading-up and to provide a platform for pushing through price increases. The volume gains from its global drive brands suggest that innovations in filter technology and packaging are working. Analysts estimate that price increases and a higher proportion of premium sales boosted earnings by around 9 per cent, and Mr Adams believes that further price increases are possible. "Pricing momentum is not a flash in the pan, we've seen it over the past two years," he said.

More generally, even though share prices have risen steadily in the past few weeks, we remain keen to recommend defensive shares in general, and BAT in particular. The recovery in cyclical shares is being driven by news that cost reductions are propping up profits, combined with the hope that demand must return because it has stopped deteriorating. However, quite when solid demand will emerge is anyone's guess, so the rally may suffer an abrupt reversal if demand fails to materialise. In the meantime, we prefer shares in companies such as BAT, where forecasting demand doesn't require a crystal ball. Despite a continual battle against stiffening government regulations around the marketing of cigarettes, and the effects of tax increases on demand, people continue to smoke. And, in an ironic twist, the effect of governments' attempts to stifle the supply of smuggled cigarettes seems to be boosting sales volumes of the duty-paid ones.

Besides, as analyst Chas Manso de Zuniga of stockbroker Evolution Securities, points out, his earnings forecasts for BAT aren't at all demanding (see table). On his numbers, the shares trade on a PE ratio of just 13 times earnings for 2009 and generate a dividend yield of 5.2 per cent. But he thinks material upgrades to his estimates are possible.