British American Tobacco is well placed for the RRP ‘arms race’

British American Tobacco (LON:BATS) has enjoyed a very successful decade. Its shares have risen by 225%. That’s 11x the capital gain of the FTSE 100, and 3.4x the return on its only UK-listed rival, Imperial Brands. However, I think British American Tobacco will in future enjoy an even more successful decade because it is acquiring the 57.8% of US tobacco company Reynolds which it does not currently own.

The deal will create the biggest tobacco company in the world. It has the potential to make larger investments than its rivals, produce cigarettes and e-cigarettes at lower costs than its peers, and take full advantage of its pricing power. It will also offer relatively high diversification and potentially lower risks than its peers due to its sheer size. As well as this, I believe British American Tobacco still has a relatively low valuation as well as bright income prospects. Therefore, I feel it’s a strong buy for the long term.

A changing industry

The tobacco industry is changing rapidly. While not quite a revolution, it is evolving at its fastest pace in a generation. In recent decades, tobacco products in one form or another have dominated sales within the industry. While there have been variations such as filter cigarettes, menthol and other innovations, the product has essentially been tobacco-based. Now, a new era of products is being embraced and British American Tobacco’s acquisition of Reynolds puts it in pole position to take advantage in my opinion.


Reduced Risk Products (RRPs) aim to deliver the same taste and feeling as a traditional tobacco product, but with far lower health risks. The first popular iteration of RRPs has been e-cigarettes, which continue to offer a CAGR of 20%+ and are likely to do so over the next few years. However, this is very unlikely to be the end of RRP development, since Philip Morris has already launched a new RRP called Marlboro HeatSticks. They heat, rather than burn, tobacco and apparently provide a much more cigarette-like experience than e-cigarettes.

The development of any new product means R&D and investment. In my opinion, the tobacco industry may be on the cusp of an ‘arms race’ towards more RRPs, which gradually mimic the appearance and experience of a traditional cigarette but with minimal health risks. Since British American Tobacco will be the biggest tobacco company in the world, it could have the deepest pockets to finance new RRPs. Therefore, it would not surprise me if it gradually exerted greater dominance in the new and exciting RRP space, which may translate into increasing profitability.

Traditional dominance

While RRPs represent the future, the bulk of sales and profit for the industry is likely to come from tobacco-based products for the foreseeable future. Since tobacco is such a mature industry, it is unlikely that costs can easily be reduced by any single entity. However, a merged company such as British American Tobacco and Reynolds is likely to have a competitive advantage when it comes to costs, in my view.

…a merged company such as British American Tobacco and Reynolds is likely to have a competitive advantage when it comes to costs…

The combined business is estimated to deliver at least $400 million of annualised cost synergies by the end of year three. This should support continued margin improvements and could allow the company to ease up on price increases, which have been a feature of the tobacco industry in recent years. Of course, it could choose to raise prices in line with industry rivals, in which case its earnings and free cash flow may rise at a faster pace than average.

A sound investment

Higher earnings and stronger free cash flow could mean higher dividends in future. British American Tobacco has committed to paying out 65% or more of earnings as a dividend each year. In my view, this is slightly conservative, as British American Tobacco had a payout ratio of 68% in 2016. Still, it means there is unlikely to be a significant change from an income investing perspective in the short run. In the long run, dividends could rise faster than they have in the past owing to rising profitability, which makes the company’s 3.3% yield all the more appealing, in my opinion.


Since British American Tobacco has a forward P/E of 18, many investors may feel its valuation is excessive. Compared to Imperial Tobacco’s forward P/E of 14.4, that may be the case. However, US rivals Philip Morris and Altria (who are also among the five biggest global tobacco brands in the world, excluding China Tobacco) have forward P/Es of 21.3 and 21.2 respectively. Therefore, British American Tobacco’s valuation starts to seem more appealing. Particularly so, in my view, since the US dollar may strengthen as US monetary policy tightens, while sterling could sink lower as Brexit discussions get underway.

Outlook

As with any merger or acquisition, teething problems cannot be ruled out. However, in my opinion there is a relatively low risk of this for British American Tobacco since it already owns a sizeable portion of Reynolds. The deal has also been supported by both management teams.

In the long run, I believe a more dominant position within the tobacco industry will mean British American Tobacco enjoys even greater success than it has done in the last decade. I think it will provide a competitive advantage in both RRP investment/development and in cost advantages versus rivals. This could give the company greater pricing power, as well as higher earnings and cash flow. In turn, this may translate into a faster rising dividend than would normally have been the case, and more income appeal when UK CPI is moving higher.

While British American Tobacco is by no means a cheap stock, I think it is fair value relative to other global tobacco stocks such as Altria and Philip Morris. Therefore, I believe its shares could move significantly higher in the long run. Investing in tobacco stocks may not be for everyone, and the ethical reasons for avoiding the sector are completely understandable. However, from a purely logical investment standpoint, British American Tobacco is a strong buy, in my opinion.