Tobacco Offers Stable Income

THE INCOME INVESTOR: Smoke out inflation-busting yield with this fairly-valued defensive stock with strong brand loyalty and cost advantages

Philip Gorham 29 April, 2014 | 12:19PM

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.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
British American Tobacco PLC3,189.50 GBX-2.57
Imperial Brands PLC1,466.50 GBX-2.53
Philip Morris International Inc73.36 USD-0.20

About Author

Philip Gorham  

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