Buy BATS for income

As of last week’s 2018 full-year results, BATS has made significant progress with its alternative products. Revenue from tobacco heating products (THPs) and vapour, together dubbed 'next-generation products' (NGPs), increased 95 per cent to £901m – slightly beating BATS’ target of £900m in sales from alternatives. Sales from THPs increased by 180 per cent to £576m, while vapour sales were 26 per cent higher at £325m. BATS reiterated its goal of generating £5bn in revenue from these alternative products by 2023-24.

True, those targets were scaled back during 2018 from £1bn of sales and £5bn by 2022, but the slower take-up suggests a slower move from traditional combustible products, the heavy regulation of which supports BATS' ability to achieve bumper underlying operating margins, which came in at 42 per cent last year. 

But over the long term, growth in NGPs is meant to compensate for the declining popularity of traditional cigarettes. On a representative basis (if BATS had owned Reynolds America and its other acquisitions for all of 2017), total cigarette and THP volumes fell 3.5 per cent to 708bn units. But the 2.7 per cent volume decline in key markets actually outperformed the sector, where volumes fell 3.4 per cent, resulting in a 40 basis point gain in market share. Within what BATS has dubbed its “strategic portfolio” of cigarettes and THPs, volumes improved 5.8 per cent, with revenue up 8.5 per cent to £18.1bn at constant rates – making strategic products the biggest source of revenue.

On the face of it, the income offered by holding BATS shares is reason enough to buy them, although the forecast yield of 8 per cent is so high it's tough to believe it is the real thing. Indeed, net debt of £43.4bn, or four times cash profits, is a major concern and finance costs last year stood at £1.5bn. Nevertheless, the full-year dividends for 2018 increased 4 per cent to 203p a share. What's more, cash generation was strong. BATS generated £10.3bn from operating activities, with operating cash flow conversion of 113 per cent compared with 79 per cent in 2017. Free cash flow was up 120 per cent to £7.7bn, aided in part by the Reynolds deal, and was enough to comfortably cover the £4.3bn dividend bill for the year.

While debt is elevated, the company has something of a balancing act on, so it has not helped that the tobacco industry is not without its challenges. The chief fear is that regulation, especially in the US, is getting stricter. American regulator the Food and Drug Administration (FDA) has considered cutting the amount of nicotine that can be allowed in combustible cigarettes, putting heavier regulations on menthol cigarettes, and has threatened an investigation into whether it should ban some flavoured e-cigarette and vaping products because of their popularity with teens. BATS is more exposed to the US market than its UK-listed peer Imperial Brands (IMB) after the acquisition of Reynolds America. The company also recently announced it will take a £436m provision on its 2019 income statement (treated as an adjusted expense) after the Quebec Court of Appeal in Montreal ruled against BATS on two lawsuits.

Further uncertainties exist about the potentially disruptive influence of NGPs on the market, however BATS' progress here has been encouraging, not withstanding its hiccups over targets.