Wealth Building
Smoking success
The winner for the next decade.
I am not sure if it is just me, but I can't stop hearing bad news spewing from many of the once high-flying ALT-X listings that were flavour of the month not too long ago.
If it's not a case of missing market expectations on results, it has been director indiscretions or sudden surprise sell-outs to larger and more established main-board competitors. None of this should surprise anyone. This is not an economic environment well suited to weak and untested companies with feeble management. Now is a time when quality counts and big is better, two crucial ingredients for investing that I suggest might become even more important in the next few years as governments slowly extract their enormous artificial stimulus from the financial system. As this occurs, companies will increasingly have to rely on their own sustainable business models. One company which we expect to continue to thrive during tough times is British American Tobacco (BAT). So why should BAT prosper and what makes it an attractive investment?
BAT has a proven history:
This is a company which was founded in 1902 and within a decade became one of the largest businesses of its kind globally. BAT has weaved its way through a maze of potentially crippling events over its century of existence. These included government sin taxes (BAT claims that in 2008, governments earned 22 billion pounds or 8 times the Group's PAT from sin taxes), class action suits, draconian advertising and promotion bans that have shut-out marketing the product in many countries, legislation to curb usage and illicit trading, which now accounts for 6% of global output and undermines pricing.
It has size advantage
Of the 1 billion people that smoke on earth, 1 in 8 people smoke a BAT brand. BAT subsidiaries produce 715 billion cigarettes in 49 factories in 41 countries and employ 50 000 employees. BAT brands are sold in more than 180 markets around the world and the company enjoys brand leadership in 50 of these markets. It is one of the few international major cigarette producers that has major interests in tobacco leaf growing and it bought 390 000 tonnes of leaf in 2008 from 300 000 tobacco farmers and 80% of these operate in emerging markets.
It operates in a concentrated and resilient market:
The global tobacco industry produces more than 5500 billion cigarettes a year with China 'boasting' the largest base of consumers, 350 million people smoking 2200 billion sticks or 40% of the global total. The Chinese tobacco industry is state owned which further accentuates the concentration of the industry. Excluding China, the four largest tobacco companies control 46% of the world's output. In order of size these are Phillip Morris International (16%), BAT (13%), Japan Tobacco (11%) and Imperial Tobacco (6%).
BAT has a definite corporate strategy that works and has been tested:
The strategy is based on four simple dictums; increase volumes, innovate, improve pricing and save costs.
Volume growth, the most elusive of the above, is derived from acquisitions and organic growth. Whilst the company had been hoping for volume gains, the latest global economic crisis has seen volumes shrinking by as much as 2% annually. BAT management are, however, very aware of the volume growth constraints within the markets in which they operate. This is depicted by the following quote from CE Paul Adams: "generally speaking, we think smokers will consume fewer cigarettes each year and smaller percentages of populations will smoke. However, the number of adults in the world over the age of 20 is forecast to grow around 11% over the next ten years. As a result, we expect global annual sales will be broadly unchanged in a decade's time."
Pricing improvements have been achieved by a process of innovation as well as through the creation of superior brands, or premium brands, and migrating clients to these higher end brands. BAT describes these brands as their Global Drive Brands, and these are Kent, Dunhill, Lucky Strike and Pall Mall. Vogue and Viceroy are two other leading premium brands. These brands all enjoy a premium status and premium pricing. To gauge the success of this strategy, one merely has to look at the drive brands as a percentage of volumes in 2000 versus 2008. In 2000, drive brands accounted for 13% of volumes; in 2008 it was 26%. In total, top brands account for 49% of BAT's volumes as against 72% for Phillip Morris, indicating that pricing upside is still possible for BAT.
The company is clear with respect to which markets they favour as far as price and volumes are concerned. BAT is well placed as an emerging markets player. Management note that they do not target markets where profit margins are high and volumes are declining. Their preference is for geographic zones where volumes will increase, economies are strengthening and people are likely to 'trade-up' to better quality, higher margin international brands.
BAT has an exceptional track record as far as cost savings are concerned. For the five years up to 2007 a program to save one billion pounds of costs per year was successfully implemented. Supply chain and indirect costs were the target areas. A new five year plan aiming to reduce costs by 800 million pounds a year ending in 2012 has been established. This will be focusing on pooling procurement and IT rationalization and similar strategies. BAT has a history on under promising and over delivering on cost reduction.
The Group has produced exceptional financial results and is guided by a strong management team:
I distinctly remember a time during the late 1990s when negativity towards tobacco companies was at its height. IT companies were in vogue and the BAT dividend yield was double digit (in pound terms) and at a price of 300p, the share seemed to attract little interest. This has changed. The BAT management team has proven steely and adept at navigating through difficult markets and growing this business in what many described as a dying industry. Since 2000, BAT's share price has returned 22% on an annualized basis; it has delivered compound annual growth of 10% in EPS and 14% in dividends for the same period.
The reduced litigation environment and strong strategic direction has led to a rerating on the stock. Earnings growth for 2009 based on I-Net consensus is expected to be about 20% and a dividend yield of almost 5% is forecast. Growth will slow in the next two years, but in our view it is most improbable that one billion consumers will suddenly stop smoking - this is a market where predictability is high. The same cannot be said for many other more cyclical sectors where stock share prices are roaring at the moment based on overzealous investors. Added to this, BAT is a cash machine and balance sheet risk is not a concern.
This company's share has delivered a superb performance in pound terms again this year and trades at 19.50 pounds as we speak. The same cannot be said for rand investors where the strong rand has held back performance. Investing is, however, not a sprint, it is a marathon. BAT's unfaltering performance talks to quality and robustness which should demand a premium in uncertain times. Fortunately, at R235 and on a prospective PE of 11.3 times (to December 2009) and a forecast dividend yield of 5.7%, it is hardly expensive. We continue to view this stock as a core component of our portfolios.
*This article was first published by Alphen Asset Management
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COMMENTS
You forgot to mention that BAT's "tried & tested" corporate strategy sells painful and early death. I'm guessing that ethical investing guidelines don't apply much at Alphen?
by Frank on October 07 2009, 10:42
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