Following first-half results, which were very close to our expectations, we are reiterating our GBX £37.50 fair value estimate for British American Tobacco. We expect revenue to fall by 8.6% this year, driven by currency movements, and we forecast a modest rebound in 2016.
British American Tobacco (BATS) has one of the widest economic moats in our consumer defensive coverage, with strong brand loyalty and cost advantages key to its competitive positioning. As a result, the firm consistently generates adjusted returns on invested capital of almost 30%.
The two major pillars of its 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.
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, Imperial Tobacco, and Japan Tobacco, 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. Cost reduction can come from the closure of manufacturing facilities, headcount reduction, and the 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, or until it reaches the 40% operating margin of its competitors.
Another key strategy is innovation. Unlike peers in some other consumer staples categories, the international tobacco manufacturers are able to launch line extensions at a price premium to the heritage brand, and this benefits price and/or mix. Although line extensions raise manufacturing complexity, costs, and risk stretching brands, we believe it is an inherently less risky strategy than competing on price.
