British American Tobacco

EXTRACT FROM PORTFOLIO MANAGER COMMENTARIES – JULY 2023

British American Tobacco (BAT) is one of the world's largest tobacco companies with a diversified product offering, including traditional cigarettes, smokeless tobacco, and emerging reduced-risk products. Its strong presence in developed and emerging markets provides a balanced revenue stream, mitigating potential downturns in any specific region. Furthermore, the company's consistent financial performance, strong cash flows, and robust dividend history have historically appealed to income-focused investors.

BAT's reduced-risk products are a crucial component of the company's strategy to address changing consumer preferences and evolving regulatory landscapes, aiming to offer consumers alternatives to traditional cigarettes with potentially lower health risks. The company's ability to successfully transition to reduced-risk products is crucial to dealing with declining cigarette consumption, which has accelerated in recent years as consumers become increasingly health-conscious.

Despite negative volume growth, the core combustibles business is unlikely to deteriorate rapidly, owing to the strong pricing power and operating leverage embedded in the business model, allowing it to fund investment in new categories.

To date, BAT has had relatively more success with e-cigarettes but has lagged behind its peer Phillip Morris (PMI) in the important heated tobacco category. The economics of heated tobacco are generally perceived to be superior to e-cigarettes, resulting in a vast ratings gap between BAT and PMI. BAT has acknowledged it needs to improve its heated tobacco offering and has committed to investing additional resources to increase its innovation cadence to close the gap with rivals.

In late 2022, BAT suspended its share buyback program due to concerns about its debt levels and impending legal settlements. Owing to the cash-generative nature of the business, gearing levels have been brought down, and the business remains on track to move to the middle of its targeted net debt-to-EBITDA range by the end of this year, which should allow it to recommence its share buyback programme. Despite its business model resilience and strong dividend yield, BAT's valuation is now at multi-year lows. We believe the shares are attractively valued and are happy to hold them on behalf of our clients.