British American Tobacco: What We Think of the Stock After Earnings

Key Morningstar Metrics for British American Tobacco

• Fair Value Estimate
  : GBX 4,700
• Morningstar Rating
  : ★★★
• Morningstar Economic Moat Rating
  : Wide
• Morningstar Uncertainty Rating
  : Medium

What We Thought of British American Tobacco’s Earnings

British American Tobacco BATS announced that first-half revenue grew 3% in constant currency and that adjusted operating margin expanded 30 basis points to 43.7%. Reduced-risk revenue grew 17% (now 16% of total), primarily driven by its Velo nicotine pouch.

Why it matters: BAT trails wide-moat Philip Morris’ strong portfolio of next-generation products. We think BAT has made significant strides in closing the gap in nicotine pouches, but it continues to trail in heated tobacco.

• In the US, Velo has reached 31% and 26% of volume and value share, respectively, in nicotine pouches from the success of Velo Plus. As Philip Morris launches new flavors and the Zyn Ultra line, we think the Velo Max launch should help BAT remain competitive in this fast-growing market.
• It has been less successful closing the gap with Philip Morris’ Iqos in heated tobacco, as glo revenue declined 12%. We think BAT is taking appropriate steps through a premium repositioning of glo Hilo, the launch of Hyper Pro+ in Japan, and a sharpening focus on key markets.

The bottom line: We have increased our fair value estimates for wide-moat BAT to GBX 4,700/USD 63 from GBX 4,350/USD 58. The increase is driven by a more constructive outlook on BAT’s reduced-risk portfolio, reflecting an increase in our terminal enterprise value/EBITDA multiple assumption to 7.5 from 7.3.

• Shares declined 3%, perhaps reflecting some concern regarding combustibles, particularly in the US where deep discount continues to take share. However, we see this as reflective of cyclical economic headwinds rather than a secular decline for premium and value.
• We think shares are fairly valued. For tobacco exposure, we think wide-moat Imperial Brands (fair value estimate of GBX 3,300) looks undervalued, as the market appears concerned about recent volume-share losses and overlooks growing profitability.