BATS – managed decline or a successful transition?

British American Tobacco (BATS) has been forced to take a £957mn impairment charge linked to Russia’s invasion of Ukraine. The charge was made on assets designated as “held for sale” after the Kremlin suggested that it could nationalise the assets of foreign companies that pulled out of the country, although the group will be looking to arrange an orderly transfer.

The group’s half-year earnings were also constrained by a £450mn impairment designed to cover any material impact arising from an investigation underway by US authorities for a possible historical breach of sanctions. The group operates in several countries which are subject to sanction provisions.

US authorities aren’t stopping there. In April 2022, the US Food and Drug Administration (FDA) revealed a proposed tobacco product standard which would prohibit menthol as a characterising flavour in cigarettes in the US. A couple of months later the FDA announced plans to develop another product standard which would establish a maximum nicotine level in cigarettes and other combustible tobacco products.

None of this will come as a surprise to shareholders as regulatory risk is probably the defining characteristic of tobacco investments. Authorities keep putting the squeeze on traditional tobacco products, so companies such as BATS are accelerating the roll-out of non-combustible and vaping products. The New Categories segment delivered constant currency revenue growth of 45 per cent in the first half of 2022, on top of 51 per cent in 2021. Over 20mn punters now use BATS’ non-combustible brands, but you could argue that the alternative products currently provide more value on the public relations front than in terms of group profitability.

Despite rising input costs, the financial outturn has been largely positive. Revenue was up by 3 per cent on an adjusted basis, while operating profit was 7.8 per cent to the good at £5.65bn on a 90 basis point increase in the underlying margin to 43.9 per cent. “Strong cigarette and traditional oral pricing” has partially offset a 4.2 per cent contraction in sales volumes, partly attributable to the situation in Ukraine and the sale of the Iranian business in 2021. Aside from dealing with government agencies, management has also been successfully trimming the cost base with savings of around £275m made in the first half.

How the group manages the secular decline in the use of traditional tobacco products is central to the investment case, but the dividend yield on offer and the latest £2bn share buyback programme also have their attractions. You can get access to them for a modest nine times consensus earnings, probably a viable hedge in an inflationary environment. Buy.

Last IC View: Hold, 3,280p, 11 Feb 2022