BAT has been a star performer on the JSE over the last decade, beating the All Share Index (ALSI) return by 3% per year. Over this period, not only did the group deliver inflation-beating earnings growth, but the share re-rated from a forward price/earnings (P/E) multiple of 12 times in 2005 to 18 times in June 2017.
This rating change was in line with the global consumer staples sector, which benefited from the low interest-rate environment. The sector’s combination of predictable earnings growth and high dividends proved attractive as investors searched for yield.
On 28 July this year, the BAT share price declined by 7% as the US Food and Drug Administration (FDA) announced that it will look to reduce nicotine levels in cigarettes to ‘non-addictive levels’. This spooked the market, exacerbated by the recent completion of BAT’s deal to acquire the 52% of Reynolds American that it didn’t already own.
Investors should note that any FDA process will take a number of years as the regulations are only ‘proposed’ at this stage. The FDA also wants to reduce flavoured cigarettes, such as menthol, and push the use of non-combustible products (electronic cigarettes) as an alternative to traditional cigarettes.
The long time frame means there should be no impact on earnings for the next three to five years and investors can expect the same dividend growth as before.
So why then has the share price dropped? Potential new regulation decreases the visibility around longer-term earnings, which reduces what investors are willing to pay for the share, despite an unchanged medium-term earnings profile.
BAT’s management has, however, long been aware of the potential for increased regulation and will now look to engage the FDA on drafting sensible laws.
Should the new regulations come into effect as proposed and effectively reduce the addictiveness of cigarettes, BAT’s annual volume decline could deteriorate from 2022, which in turn reduces the group’s expected long-term growth rate.
BAT has a long history of successfully managing its cost base to reflect volume, mix and regulatory changes, and we expect this to continue as the group navigates future challenges.
The third part of the FDA’s proposal is to provide support for electronic cigarettes as an alternative. Reynolds American is the leader in this evolving industry and is thus best-placed to benefit. These next-generation products deliver higher margins and thus, irrespective of the FDA’s proposal, the group’s focus is to migrate customers from traditional cigarettes to next-generation products.
The tobacco industry will likely continue to consolidate, with leaders like BAT continuing to grow market share, while at the same time reinvesting cash flows to create dominance in the next-generation products. Expect the world’s largest cigarette companies to look substantially different a decade from now.
In the medium term, we remain comfortable with BAT’s ability to deliver 10% annual earnings and dividend growth in pounds. We believe the market has acted rationally given heightened longer-term uncertainty, but this should be resolved in due course. We believe BAT is fairly priced on a stand-alone basis, while offering attractive diversification for South African-based portfolios.
