Is plain packaging the death knell for British American Tobacco? As Holmes might have said to Watson, “ A two pipe job” I think, Watson!”

By Robert Sutherland Smith

British American Tobacco (BATS) – known familiarly as BATS – is a bit of a challenge. Basically, the share price lags that of Imperial Tobacco and it has found resistance to its further progress upwards at around 3,800p. Is it telling us something?

There is a constant thought in the back of the market’s mind that tobacco shares are surely coming to the end of their days. That thought has been around for years. I always quote the example of the intelligent ‘conviction’ fund manager who, twenty years ago, would not buy tobacco shares because he was convinced they would be soon out of business because of regulations. He could not have been more mistaken. The subsequent operational history of these businesses has been one of strong share price growth driven by strong dividend payouts. In the last accounts for BATS, the majority of earnings were actually paid out as dividends, which is remarkable for any business with a future. Tobacco shares have been managed to pay out dividends, rather than grow the business in the normal way via profit retention.

There is, therefore, a bearish case for BATS, and here is my interpretation of it on the basis of the situation at present.

First, and most fundamentally, is the growing regulatory fashion for putting cigarettes in plain packaging. That is a threat that the tobacco companies have hitherto been able to fight off with the argument that packages and brands do not stimulate demand for cigarettes but rather govern the success or otherwise of one company over another. Now plain packaging is in Australia, planned for the UK and attracting regulatory interest in other nations. As a leading branded cigarette business, BATS is particularly vulnerable here. After Phillip Morris, it is the biggest owner of brands – a total of 300 – though sales are driven by a few big leading brands.

Second, the share price chart shows that the BATS share price has met resistance to further upward progress at around 380p. That has been observed three times and twice over recent years. The BATS share price chart  looks to me like one with two massive ‘double tops’ – a feature which in technical analysis implies a coming fall in the share price.

Third, the BATS share price has underperformed that of Imperial Tobacco. Can one attribute that to a general belief that in an industry that cannibalises itself with acquisitions, the ultimate takeover may be of Imperial Tobacco by BATS?

There is certainly something remarkable in the operational architecture of Tobacco company returns. In the case of BATS, according to the last set of annual accounts, for 2013, the extraordinarily high margins look fatalistic and unsustainable in the long term. In 2013 gross profit margins were a remarkable 78% and net profit margins an equally remarkable 27% – remarkable because this is not in a growing market but a declining one. That picture is completed by a return of 14.5% on assets, a 22% return on investment and 58% return on equity, due in part to massive gearing of balance sheet equity with debt.     

The market consensus currently estimates a weak and sluggish top line of sales revenue until next year when it is estimated to grow by 7%. Growth in sales is important when a company has high profit margins and is paying most of those profits out as dividends. In the year just ended, BATS is estimated to have paid out about 70% of earnings as dividends. That is why they are valued on a price to earnings multiple of 17.5 times. The consensus estimates a dividend yield of 4.2% for this current year and 4.4% next year – good income as we approach the possibility of even lower inflation this spring. The forecast estimated PER is 16.7 times this year and 15.6 times next year. The net asset backing is understandably not high at a reported book value last year of 295p.          

Bears have been wrong for years, so it will be important to see what the company has to show when the results for last year appear in due course. The growth of plain packaging must surely be significant to a company which drives its sales through promotion of its big brands.