Outperforming peers

With global cigarette sales falling last year and expected to fall this year tobacco might not be an industry where you would expect good earnings growth. However, this is exactly what BATs has delivered through its focus on emerging markets, cost cutting and share buy-backs. With the stock having had a strong run recently, though, we recommend members sell half their holding.

In our last look at BATs (FAT 379, 24^th March 11) we argued that the group was modestly rated with a P/E of 12.5X earnings for 2011, which fell to 11.4X in 2012, and with a 5% yield. Since then the stock has increased by nearly 20% (£23.80 to around £28) as good results have improved sentiment and as defensive shares have come into vogue.

From a technical perspective, BATS share price continued to form a series of higher highs and higher lows over the past 12 months, underlying the strength of the broader uptrend. As evident on the daily chart, after posting a high of 2921.50p in July, prices have pulled-back slightly, suggesting that an interim high may now be in place. In our opinion, we expect a period of consolidation to emerge over the coming weeks, with downside risks limited to 2604.50p.

From a longer-term perspective, as evident on the weekly chart, prices have rallied strongly higher over the two and a half years underpinned by the upward sloping trend line. Furthermore, with the stock currently trading beneath all-time highs, we expect the broader uptrend to resume, over the coming months, upon a break above resistance.

Since announcing results for 2010 BATs has issued a quarterly update and interim earnings, re-activated its share buyback programme and made a small acquisition. These have underpinned that it is business at the tobacco giant and commenting on the interim results the group’s chairman stated:

“With continued pricing momentum, an increase in market share and the rate of volume decline moderating, we are on track for another very good year.”

Turning to the buy-back first and this was re-started this year after being suspended for 2009 and 2010. In the first half of 2011 the group spent £335m buying back 13m shares at an average price of £25.76. This comes to about 0.65% of the voting shares outstanding at the end of 2010.

Not enough to boost earnings significantly but if carried out over time the difference made can be significant. The total amount allocated towards buy-backs for 2011 is £750m which provides plenty of further firepower although at a higher stock price.

On the acquisition front and the group has spent US$452m buying the Columbian cigarette business Protabaco (announced 26^th May and subject to the necessary approvals). This moves BATs to become the second largest cigarette company in the country and illustrates the focus on emerging markets growth.

As we discussed in our last look at BATs, the company has an impressive emerging markets exposure. Of the BRIC economies the group has a 74.6% market share in Brazil and a 20% market share in Russia. In South Africa the market share is 85% while it is also above 80% in Venezuela, Uzbekistan and Chile.

As these are fast growing economies this helps offset the 2.5% global contraction in cigarette volumes that incoming BATs CEO, Nicando Durante, has predicted for 2011. This compares to a fall in volumes at BATs of 2% in 2010 driven by an 8% drop in Western Europe while Asia Pacific was the only region to see a volume increase.

For the 2011 half year the group states that global cigarette volumes fell 1% to 344 billion but the market share of BATs increased. Asia Pacific and the EEMA (Eastern Europe, Middle East and Africa) saw flat volumes while the other two regions saw declines:
 


Within this the four “Global Drive Brands” of the group achieved overall volume growth of 11%. Dunhill saw volumes rise by 1%, Kent rose by 16%, Lucky Strike by 8% and Pall Mall by 14%. The brands did well in different countries but emerging markets were important for all of them – increased penetration of these brands helps drive margins and profits.

As a reminder, in 2010 BATs saw 15% adjusted EPS growth and lifted its dividends by the same amount. This was as revenue increased in all regions except Western Europe and in total rose by 5%. However, taking out currency effects (constant currency basis) revenue was flat.

Turning to results for the half-year and revenue increased by 2% which helped boost adjusted diluted earnings per share by 10%. In a sign of confidence BATs increased the interim dividend by 15%.



What is particularly notable for the year so far is that organic revenue at constant exchange rates rose by 7% (contrasting to 2010). Taking a look on a geographical basis and all regions saw adjusted profit from operations. Western Europe just about held its own while a robust performance was had elsewhere.



Overall then the first half results are encouraging with overall revenue growth and profits growth in all regions. The stock has more than lived up to its billing as a defensive investment while emerging market exposure has provided good growth.

This is illustrated by our strong gain on the stock despite buying it in May 2008 only months before the Lehman triggered downturn. A gain on the stock including dividends of over 50% since purchase is therefore a robust achievement.

The rapid 20% move in the last few months, though, provides an opportunity to bank some profits as the rating has moved up to 14.4X the current year and 13.2X next year’s earnings. For 2012 the yield is around 5% while for 2015 the P/E falls to around 10X ensuring we continue to hold the stock as a defensive investment.

Accordingly, we recommend members sell half of BATs.