British American Tobacco (BATS) has one of the widest economic moats within our consumer defensive coverage, with strong brand loyalty and cost advantages key to its competitive advantages. As a result, the company consistently generates adjusted returns on invested capital of almost 30%. The two major pillars of British American's strategy are product innovation and cost reduction, and while we recognize the importance of each strategy, we suspect the two might be difficult to achieve simultaneously. Nevertheless, we hold the business in very high regard and would be buyers of the stock at a discount to our fair value estimate.
Tobacco brands have created a loyalty among users
Despite the strength of the business, British American generates operating margins in the high-30% range that are in line with the international business of Japan Tobacco, but below those of its three main competitors: Philip Morris International (PM), Imperial Tobacco (IMT), and Japan Tobacco (TSE), each of which generates margins north of 40%. Therefore, we believe there is room for margin expansion and that management's medium-term target of an annual operating margin of 50 to 100 basis points is realistic. We think cost reduction can come from the closure of manufacturing facilities, headcount reduction and the company's SAP rollout. We see little flexibility at the gross margin given that the firm's scale already gives it significant pricing power over the suppliers of tobacco – almost one third of cost of goods sold, and other direct materials and that direct labour is already a very small component of cost of goods sold. Nevertheless, we expect British American to be able to remove around £100 million in costs per year for the next three to four years.
Another key strategy is innovation. Unlike peers in some other consumer product categories, the international tobacco manufacturers are able to launch line extensions at a price premium to the heritage brand, and this provides a boost to price and/or mix. Although, line extensions increase manufacturing complexity, costs, and risk stretching brands, we believe it is an inherently less risky strategy than competing on price.
Tobacco brands' intellectual property has created a loyalty among tobacco users toward the brands they enjoy. British American has an impressive brand portfolio that is quite evenly balanced across price points. In spite of the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. In fact, it is the bans on advertising that help to keep market shares stable and new entrants out. British American’s premium offerings, which comprise around one third of its portfolio volumes, include Dunhill, Kent, Lucky Strike, and Rothmans.
Historical returns on invested capital lend support to our wide moat rating. British American has generated returns on invested capital in excess of 20% on average over the last five years, and we forecast returns to remain at or above 25% over the next five, comfortably ahead of our 8% estimate of the firm's weighted average cost of capital.
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