BAT Earnings: New Categories Drive Improvement but U.S. Cigarettes Look Very Soft

British American Tobacco BATS reported an encouraging performance in the first half of 2023, with year-over-year organic revenue growth of 2.6%, slightly better than our forecast. The positive news was an improved performance in the New Categories portfolio, although we remain skeptical about the durability of current levels of growth. On the other hand, and as expected, volume in the U.S. market was weak, implying a negative read-through for Altria’s second-quarter results. We believe this is a cyclical impact of high food and fuel prices in the United States, and assuming limited change in the employment rate, we continue to believe the market will rebound going into next year. Although we prefer the portfolio of Philip Morris International, we believe BAT’s challenges are more than fully priced in and that the market price presents a defensive investment at an attractive valuation. We retain our GBX 3,900 fair value estimate and wide economic moat rating.

Constant-currency revenue growth of 2.6% was supported by 26.6% growth in revenue from the New Categories division, which represented 12% of total net revenue in the first half. This is similar growth to that reported by Philip Morris International and was driven by strong volume growth of 32.2% in modern oral products. In heated tobacco, however, BAT is still underperforming PMI, and it lost share to the tune of around a percentage point on a global basis in the first half of the year, while PMI gained share. BAT claims that it is “on track” to meet its target of GBP 5 billion in revenue by 2025 in its New Categories division, but we think this relies on strong execution and continued growth of oral pouches, both of which seem plausible but are not guaranteed. Besides, we remain doubtful that margins in the vaping category will get anywhere near those in the core cigarette business, and we continue to believe revenue targets are a suboptimal metric on which to measure performance in adjacent categories.