ANALYSIS: Is BAT going up in smoke?
A plan to lower nicotine levels, coupled with allegations of bribery and cover-ups, rattle local investors
The warm glow of market sentiment usually reserved for highly profitable cigarette giant British American Tobacco (BAT) has been unceremoniously stubbed out.
BAT’s shares on the JSE shed more than 9% in the two days after the US Food & Drug Administration (FDA) proposed drastically reducing the amount of nicotine in cigarettes to "nonaddictive levels".
FDA commissioner Scott Gottlieb said 480,000 Americans die every year due to their addiction to cigarettes — "the only legal consumer product that, when used as intended, will kill half of all long-term users".
But the stock slide was severe for the company, which, with a market capitalisation of R2.03 trillion, is the second-largest on the JSE after AB InBev (R2.69 trillion) — especially as BAT has been typecast as a defensive stock since it listed in 2008, and thus supposedly immune to such swings.
At the time of writing, BAT’s share price had shown only a modest recovery, as analysts struggled to get a sense of what Gottlieb’s rules would mean for the company’s value.
New York-based brokerage Cowen cut its one-year price target for BAT by 10% to R801.36/share — lower than the stock’s current level of R842/share. Top-ranked SBG Securities analyst Rey Wium cut his price target to R986/share, which is still far above the current price.
This reflects the concern that traditional tobacco companies such as BAT are locked in a losing battle with governments eager to clip their wings.
For BAT, which finalised its acquisition of the last parts of US tobacco company RJ Reynolds in recent days, it’s a serious knock. But it should push the company to fast-track its move to e-cigarettes and vapour products.
The big question for local investors is whether BAT still offers smouldering value. Lentus Asset Management chief investment officer Nic Norman-Smith believes BAT is a great example of why investors need a margin of safety built into valuations.
"The risks to BAT are not new risks. Governments have been pushing against smoking for a long time ... but BAT has been trading at an earnings multiple of over 20 times. A defensive company is only defensive at the right price," says Norman-Smith.
In a note to clients, boutique investment firm Vestact says there will still need to be much talking and discussion with the public and the industry around the FDA’s proposed rules.
The FDA said it plans to begin a public dialogue about lowering nicotine levels. "The agency intends to issue an advance notice of proposed rulemaking to seek input on the potential public health benefits and any possible adverse effects of lowering nicotine in cigarettes."
Vestact points out that the plan for tobacco companies is to have e-cigarettes replace traditional cigarettes. "But if the nicotine levels are much lower, will that switch still take place?"
Vestact says smoking numbers have dropped in the developed world for more than two decades, yet the share prices of tobacco companies have not reflected this.
"There is only so much merger and acquisition activity that can be done and price increases to offset lower sales," said Vestact.
Though smoking is on the decline worldwide and cigarette volumes are gradually dwindling, BAT has immense operational leverage through pricing power on an addictive product sold in a highly regulated market.
But just as investors were beginning to get to grips with the new FDA proposals, investor sentiment got smoked again — this time as the Serious Fraud Office in the UK confirmed it has opened a formal probe into BAT.
The allegations, which date back years, relate to bribery and misconduct at its African operations, including in SA.
In 2015, former BAT employee Paul Hopkins detailed how he paid bribes to officials in East Africa, which were used to pay government officials in Burundi, Rwanda and the Comores Islands.
Last year, a whistleblower who worked for BAT SA’s former security company, FSS, claimed the tobacco company had also paid bribes to police and SA Revenue Service officials.