BATS: Reynolds deal boosts income case

British American Tobacco (BATS) is a new entry in this year’s Income Majors list following its acquisition of Reynolds America. The £41.8bn deal was the largest ever purchase of a tobacco company, and one of the biggest M&A deals in history. Understandably, this has dramatically affected the scale of the company, and with it the shareholder payout.

The Reynolds deal boosted the 2017 top line by38 per cent to £20.3bn, while operating profit increased by 39 per cent to £6.5bn. Less impressive were cigarette volume sales, up 3.2 per cent on the previous year to 686bn sticks. Strip out the contribution from Reynolds, and that figure fell 2.6 per cent – less than industry-wide declines, but a decline nonetheless.

Falling sales of traditional cigarettes has forced tobacco companies to turn to other products that deliver nicotine, as the nascent vape industry attests. These so-called ‘next generation products’ (NGPs) generated £461m in revenue during 2017, although this still pales in comparison to the contribution from combustible tobacco products. However, the near-term growth ambition is massive: management is aiming for £1bn in sales from NGPs during 2018, and around £5bn by 2022. By that point, analysts at Liberum estimate alternative nicotine hits will make up around a fifth of BAT’s sales. For those with a distant income horizon, the analysts predict NGPs will command 30 per cent of sales by 2030, rising to 50 per cent by mid-century.

Whether NGPs can compensate for declining numbers of cigarette sales fast enough should matter to income investors as it will determine whether BAT can maintain its chunky payout ratio. Indeed, who would want to own a tobacco stock were it not for those distributions? In 2017, the full-year dividend was increased by 15.2 per cent to 195.2p, paid in four instalments. An additional 43.6p was paid in February this year as part of the transition to quarterly dividends, and the company is committed to passing on at least 65 per cent of earnings direct to shareholders. In 2017 its payout ratio was 69 per cent.

Payments to shareholders were supported by a 16 per cent increase in net cash generated from operating activities, to over £5.3bn. However, payment of the Master Settlement Agreement liability in the US meant that cash conversion fell to 83 per cent in 2017, down from 99 per cent a year before. Conveniently for its executives, the company’s definition of cash conversion for long-term incentive purposes strips out this liability payment and other adjusted items to arrive at 96 per cent. It’s rarely worth discounting legal liabilities when it comes to vice stocks.

Still, billions continue to find their way to shareholders. Last year, the group shelled out £1.1bn in interest payments, and £3.5bn in dividends, up from £2.9bn in 2016. Yet one might wonder whether such generous payments could come at the expense of potential spend on innovation for NGPs – a point we also flag for Imperial Brands’ income case. Liberum analysts estimate that BAT will generate around £6.6bn of free cash flow in 2018. If the dividend payout ratio is kept flat on 2017 at 69 per cent, ahead of the stated 65 per cent floor, then that would leave £2.4bn left over to pay down debt and perhaps invest in product development.