British American Tobacco's (BATS) interim 2014 results were very close to our expectations and we are reiterating our £35 fair value estimate. It was a robust start to the year, with the firm continuing to outperform Philip Morris (PM) in several geographies, lending support to our belief that the firm has a wide economic moat.
The strength of sterling was again a significant headwind for British American in the first half of the year, but on an underlying basis, results were in line with what we believe to be the business' long term algorithm. Reported revenue fell 10% but rose 3% on a constant currency basis, with foreign exchange being particularly unfavourable in the Americas segment. The underlying performance was in line with our long term assumptions, with modest volume declines being more than offset by higher prices.
On a regional basis, British American appears to be performing well in geographies in which Philip Morris International is struggling, and vice versa. In Western Europe, where Philip Morris last week reported second quarter share gains, BATS underperformed the industry, with underlying volumes and EBIT both down 6%. In Asia, on the other hand, BATS's largest EBIT (earnings before tax) contributor and a market in which Philip Morris has lost share in recent quarters, BATS grew volumes by 3.6% and constant-currency EBIT by 6%. In both of these cases, we believe temporary factors are at work. In Western Europe, switching back to favourite brands driven by economic stabilization created a positive mix effect for Philip Morris' premium-skewed portfolio and a headwind for BATS. In Asia, we believe the shift to machine-rolled kretek cigarettes in Indonesia is a tailwind for BATS but will be a drag for Philip Morris until it gains a stronger foothold in the machine-rolled category.
British American indicated that performance had been strong in Australia, and we believe this could be a sign of a more secular trend. Australia introduced plain packs in 2012, a policy that we think could lead to trading down as consumers become less willing to pay a premium for products lacking brand identity. This appears to be playing out, with Philip Morris citing trading down as a major contributor to its 6% decline in Asian volumes, while BATS, whose portfolio is more balanced across price points, was able to take pricing.
Although we estimate that Australia represents only around 1% of volumes and 6% of EBIT for BATS, and slightly lower for Philip Morris, the early indications are that plain packs are causing smokers to switch to lower-priced brands. We believe that both British American and Imperial Tobacco (IMT) are better positioned than Philip Morris to retain share in the event of plain packs legislation spreading to other major markets.
Higher prices and BATS's ongoing cost initiatives generated a strong margin performance, in line with guidance despite the currency headwinds. The operating margin grew by 30 basis points to 39.2%, and although we think the firm's presence in discount categories will be a structural barrier to BAT's operating margin from reaching the levels of Philip Morris, we expect another 300 basis points of margin expansion potential over our five-year forecast period.
Nevertheless, with the stock trading close to our fair value estimate, we believe this opportunity is priced into the stock, and we recommend Philip Morris to long-term investors willing to ride out the current cyclical headwinds and to accept the potentially disruptive risk of plain packs.
