BAT drives free cash flow as efficiencies kick in

British American Tobacco (BATS) is getting on the 'great reset' bandwagon. As part of its “Building a Better Tomorrow” initiative, it has added another 3m vapers to its ranks, taking the total to 13.5m, and is on track to hit the 50m mark by 2030. That meant that revenues from its 'New Categories', essentially vapour and tobacco heating products, increased by 15 per cent.

The development of markets in non-combustible products is central to the group’s business model, given the secular decline in the use of conventional tobacco products, at least in western markets. The group pumped in another £426m in New Categories investment through 2020, as sales accelerated through the second half of the year.

Although the group’s traditional products still account for almost 90 per cent of sales, volumes are in decline – by 4.5 per cent through the year. Nevertheless, the top line held up through 2020, bolstered by a more favourable pricing mix.

Management is ahead of schedule in its bid to deliver £1bn in annualised cost savings by 2022 to fund investment in its new categories. Yet these improved efficiencies were already reflected in a 4.8 per cent rise in adjusted operating profits to £11.4bn, on an underlying margin increase of 100 basis points.

There were also encouraging signs for any income seekers within the shareholder ranks, as free cash flow after dividends was up by around a third, while borrowings contracted through the period. BATS’ inventory marches out the door at a rapid clip, so the cash conversion rate was as healthy as ever. Strengthening cash generation reduced net debt as a proportion of cash profits to a multiple of 3.3, from 3.5 the prior year.

Looking ahead, we cannot be sure that pricing will remain favourable through 2021, but even with the general disruption brought about by the pandemic, the group still expects to deliver constant-currency revenue growth of 3-5 per cent this year, and constant-currency adjusted earnings growth in the mid-single digits.

Sales volumes for the 'Vapour' segment increased by 52 per cent through the year. That is impressive even in an immature market, although it remains to be seen whether growth rates like this (unsustainable over time) will be sufficient to mitigate falling revenues from conventional tobacco products. Improved cash management and an alluring yield support the investment case, but we would not feel confident recommending the stock while regulatory issues remain over new products. Hold. 

Last IC view: Hold, 2,902p, 09 Dec 2020