Facing legal and regulatory actions involving claims of personal injury and economic loss, as well as swelling anti-smoking sentiment fuelled by anti-smoking campaigns, British American Tobacco (BAT) is forging ahead in transforming tobacco. Investing heavily in creating an alternative product with less harmful toxins, it has termed this new line Next Generation Products (NGP).
BAT distinguishes between tobacco products, which require combustion (producing toxic smoke), and “potentially reduced-risk” products, being vapour, tobacco heating, oral tobacco, and nicotine products.
Hence, ‘alternative tobacco products’ refers to non-combustion products, which either heat the tobacco (producing a tobacco-tasting nicotine-laced aerosol), or a liquid (which may contain nicotine) that produces a vapour to be inhaled. It is the action of heating, as opposed to burning, that reduces the harmful impact on health, according to industry funded research. Vaping products don’t necessarily contain nicotine derived from tobacco plants. The synthetic version of nicotine is prohibitively expensive, but the cost may reduce in time.
The group has embarked on an extensive scientific research programme and is investing heavily in the development and commercialisation of the global NGP market, expressing confidence that it is set to more than double between 2016 and 2021. Much has gone into design and development, resulting in attractive small sleek products such as glo and glo iFuse, which can be held in one’s palm, or the e-pens closely resembling their namesake.
The NGP products may escape the wrath of the anti-smoking lobby for now. However, there is no guarantee that the tobacco giants will be in control of the rapidly developing NGP market. BAT faces strong competition from other vapour-like products, such as Juul, which is owned by a small San Francisco based company, Juul Lab. It is too soon to tell if vaping is attracting smokers, or growing a new market from non-smokers.
In July 2017 BAT acquired the remaining 57.8% share in Reynolds American Inc for £41.8 billion, becoming the world’s largest e-cigarette maker. The acquisition was funded in part cash, part equity. For each share, Reynolds shareholders received US$29.44 in cash plus 0.5260 BAT ordinary shares (BAT American Depositary Shares); 429 million new BAT ordinary shares underlying the BAT ADSs were listed on the London and Johannesburg stock exchanges, resulting in the share capital increasing by 21.19% from £507 million to £614 million. The bulk of the net assets acquired included intangible assets of £75.5 billion, goodwill of £41.8 billion and deferred tax liabilities of £27.4 billion.
The group’s products include vapes, oral tobacco, and nicotine replacement therapy products (such as nicotine-free patches), which are sold in over 200 markets. Its leading brands include Kent, Dunhill, Lucky Strike, Newport, Camel, Rothmans, Pall Mall and Natural American Spirit cigarettes, and vapour brands Vype ePen and Vuse. Vuse sales are growing in volume despite a product recall relating to a consignment of malfunctioning batteries.
The Reynolds acquisition boosted group revenue by 32.6% to £19.6 billion at December 31 2017 (revised in the unaudited 2018 interim accounts), and £11.6 billion for the six months to end June 2018 (six months to end June 2017: £7.4 billion). Total borrowings have increased to £48.5 billion (six months to end June 2017: £20.9 billion). Net finance costs for the six months to end June 2018 were £701 million (six months to end June 2017: £325 million). The net cash generated from operations as a percentage of profit from operations is 86.9% (six months to end June 2017: 66.3%).
The bulk of the intangible assets in the group balance sheet is made up of goodwill and trademarks (or similar). The intangible assets are valued at £120 billion (compared to £12.2 billion at end June 2017), and constitute 84.21% of total assets (up from 31.07% at end June 2017). If the group does not manage to significantly grow its revenue, the heavy presence of the intangible assets would start weighing down the balance sheet. The financials do not provide a breakdown of the intangible assets, and it is therefore not possible to ascertain the split of intangibles between the combustible products and the NGPs. The substantial investment in intangible assets may yet be BAT’s Achilles Heel.
The extensive public relations exercise in brand awareness, cognisance in the mind of the consumer of the alleged reduced risk from heat-not-burn (HNB) products, the industry funded research, and the weighty legal machinery all come at a huge cost. Nonetheless, the profit after tax for the six months to end June 2018 is £2.8 billion (up from £2.3 billion in the six months to end June 2017). The “other operating expenses” for the period jumped to £3.1 billion (from £1.5 billion in the six months to end June 2017).
BAT is facing complex litigation in many jurisdictions, ranging from claims for personal loss to violations of competition and antitrust laws. Details of this litigation are comprehensively covered in some 100 paragraphs under Note 28 (Contingent liabilities and financial commitments) to the 2017 annual financial statements. Yet the group is confident that it will continue to win the majority of tobacco-related litigation, or that these claims will be dismissed at or before trial. It has been argued in court that governments and adults have known about the risks associated with smoking for generations. Accordingly, no contingent financial liabilities have been raised. The group is also facing an ongoing investigation into misconduct allegations, and is liaising with the UK’s Serious Fraud Office. A decision is awaited from the Quebec Court of Appeal on an appeal heard in November 2016 in connection with the Quebec Class Action.
The share price high point on the London Stock Exchange on May 26 2017 (prior to the acquisition) was £55.91. The share is now trading between £41.49 and £42.21. The reasons for the decline are a combination of the strengthening of the pound against the dollar (resulting in lower revenue from the US operations), increasing US interest rates, and the decline of vaping in Japan and South Korea. The vagaries of the Rand against the pound added further Rand volatility in the share price.
The share is currently trading between R734.01 and R753.62 on the JSE.
It is unlikely that BAT will escape the legal minefield in marketing non-combustion products. Various jurisdictions have different regulations governing the nicotine content of e-cigarettes, and many ban the advertising of e-cigarettes. In years to come, as-yet unidentified health risks may emerge. It is to be noted that the South African Tobacco Bill does not acknowledge any distinction between heat and burn, and includes vapour and aerosols in the definition of smoking.
Come what may, BAT is on the campaign trail of transforming tobacco – anticipating that it will benefit “consumers, society and investors alike”, and is confident that its next-generation products are “committed to delivering sustained long-term profit growth and returns”. In 2018, BAT expects to generate over £1 billion in revenue from NGPs, rising to more than £5 billion in 2022. The subliminal message is “Don’t combust and burn, heat and vape”.
Barbara Curson owns shares in BAT.