British American Tobacco's 'new categories' approaching breakeven

Tobacco merchants such as British American Tobacco (BATS) have in recent years been pushing hard to convince the market about the benefits of a strategic shift into non-traditional products as secular trends play against cigarette sales. This diversification isn’t necessarily a panacea to the ills of the industry, though, given health issue concerns relating to new items and an ongoing pushback from regulators. And investors have been wary about the pace of the company’s transition away from cigarettes, with combustibles still taking over 80 per cent of total sales despite positive movement in the half. 

Judging by these results, progress is being made on the company's ‘new categories’ (which contains vapour, THP, and oral pouch products) front as the Dunhill and Lucky Strike maker aims to turn this division into a £5bn business by 2025. Segmental revenues were up by 29 per cent in the half to £1.7bn, ahead of consensus forecasts, with losses falling by 94 per cent.

The cigarette performance was helped by higher prices, but volumes fell by 5.7 per cent, driven by a 12.4 per cent contraction in the US where the company pinned its tobacco underperformance on its “premium skewed portfolio” and a flavour ban in California. Total combustibles sales were only up by 1.8 per cent, to just under £11bn. 

Overall metrics were encouraging, with adjusted operating profit up by 7 per cent to £6.02bn and underlying margin rising by 90 basis points to 44.8 per cent. 

An ongoing question is what will happen with the company’s assets in Russia and Belarus, given that “no agreement to transfer the shares in these subsidiaries has been entered into”. The company took a £957mn impairment hit in the comparative period on these subsidiaries, which are still categorised as 'held for sale' under accounting standards. Earlier this month, the Russian state seized the assets of the subsidiaries of food business Danone (FR:BN) and beer maker Carlsberg (DK:CARL), which doesn’t bode well.

The investment thesis for putting money into a cigarette business is usually centred around appealing dividends and share buyback programmes. While British American Tobacco has a chunky forward dividend yield of 10 per cent on offer, it only plans to restart buybacks once it hits the middle of its leverage target range. The shares are valued at just seven times forward earnings, according to FactSet, which is another plus point, along with the board's forecast of £40bn in free cash flow generation over the next five years. Hold.

Last IC View: Hold, 2,957p, 09 Feb 2023