British American Tobacco - "Smoking Hot"

Source from:  moneyweb.co.za 05 sep 2007 09/06/2007

And how to get exposure to it in SA. The business life cycle is heavily coached at universities with students becoming well aware of the different strategies that are most appropriate for companies to adopt as they migrate from small growth entities to mature staid businesses. One of the most interesting spaces for a company to find itself in is to be a dominant player in a mature or even dying industry. The theory dictates that in this situation the following policies should be adopted. Firstly, cut the living life out of costs and run your business as lean as possible. Secondly, consolidate the industry so competition effectively vanishes and, if need be, close these acquired businesses down. (This aims to reduce capacity in the industry to hopefully create some price traction). Thirdly, take on debt when you feel that you have achieved the first two goals as the cash flows in a mature, well run business are phenomenal and can easily keep return on equity at high levels despite a shrinking environment. I can think of no industry that is more illustrative of the mature phase of the product life cycle than the tobacco industry. No matter how one twists or turns it, tobacco is dying! Equally, I can think of no better company than British American Tobacco (BAT) that epitomises astute management when in the throes of product maturity. BAT is the world's second-biggest traded cigarette maker globally in a market which, according to the latest annual report of Altria, the holding company of Philip Morris (the world's leading global international tobacco company) amounted to almost 5,8bn cigarettes sold in 2006. BAT sells almost ten billion pounds sterling worth of cigarettes a year, covers most of the planet and earns annual pre-tax profit in excess of 3bn pounds. This is a colossal business matched only by Philip Morris on the global tobacco landscape. Whilst the magnitude of the business is impressive, what interests us even more is the process by which the company and other dominant companies within this industry are being managed. Firstly, the path of consolidation has been well trodden by the (heavyweights). From a highly fragmented industry fighting on price, global players have been reduced to approximately four major operators. In the case of BAT, whilst they too have driven the consolidation trend, they continue to seek out new opportunities and are focusing on emerging markets such as Egypt, Turkey, Taiwan and Algeria where privatisation of the tobacco industry is underway. Secondly, when it comes to cost cutting, BAT have been highly focused on driving down costs and improving operational efficiency. They have aggressively been cutting fat out of their systems, but have also attempted to find cost synergies since the BAT/Rothmans tie-up. Although they are spending monies marketing brands in countries that still allow such marketing, they will probably be able to cost cut and reduce the cost per stick well past 2008. Thirdly, BAT keeps enough debt on its balance sheet with net debt to equity a touch short of 80%, but net interest cover is a breeze with 10,5 times cover. The ROE is a most respectable 30% plus. Thus, in my opinion, the three core components of managing a maturing business mentioned above have been exceptionally implemented by Paul Adams and his BAT management team. Before concluding, we thought it appropriate to highlight some issues within their latest interim results to June and quickly comment on the investment merits of this company. For the six months to June 2007, revenue declined by 2% to £4,7bn, profit from operations rose to £1,5bn, a gain of 13% and headline earnings per share rose 9%, despite cross rates going against the company. There was a 9% forex headwind. Had it not been for some exceptional items and the exchange rate movements, profit from operations would have grown 18%. From a growth in volume perspective, subsidiary brands showed negative volume growth of 2% to 330bn sticks, but the main or global brands achieved volume growth of 6%. These results outperformed market consensus - a common BAT practice. Now for the investment merits and some of the potential risks. Although earnings have been growing robustly for years, the stock remains one of the cheapest consumer stocks in the European consumer universe and this despite a global diverse business model that is rivaled by only one larger competitor. On a price:earnings (PE) basis, BAT trades on a prospective multiple of just over 15 times 2007 earnings and an 18 month forward PE of 13,8 times. This is at a discount to the sector mean multiples. The prospective dividend yield is almost 5%. The strong cash flows and exceptional management are also compelling reasons for being invested. South African investors can own this company via Richemont where the luxury business adds a sexy sideshow or via the more staid Remgro, but with the added benefit of receiving the exposure at a discount to net asset value. Enditem