British American Tobacco's (BATS) fiscal 2010 results revealed that pricing power is intact in most markets, but that volume continued to be weak in Western Europe. We are still confident in our thesis that a balanced portfolio should allow the firm to perform relatively well in all economic conditions, and we are maintaining our fair value estimate. However, we think the modest fall in the stock price in early European trading Thursday reflects the overly optimistic expectations that had been priced into the stock in recent weeks.
Excluding the effects of the acquisition of Bentoel in Indonesia, revenue in 2010 increased 3% year over year. Although market share in the top 40 markets was up slightly, volume across these markets dipped 2%, driven by weakness in Western Europe, where volume fell 9% in the year. Excise tax increases in some key markets such as Romania, Turkey, Germany, and Pakistan have forced retail prices higher and accelerated industry volume declines. We doubt these challenges will fade in the first half of 2011, as austerity measures in some key markets as well as high unemployment and rising fuel prices are likely to encourage trading down in the near term. Although Japan remains a difficult market, the Asia Pacific region continues to perform quite well, with reported volume up 2%. Despite the pressures on volume, British American's pricing power remains intact. Even in the troubled Western Europe market, operating profit increased almost 3%. Overall, the full-year operating margin was flat, however.
We expect British American's operating environment to improve somewhat in 2011, particularly in emerging markets, and pricing should improve as the global economy recovers over time. However, road bumps remain, and with the full impact of austerity measure in markets such as the United Kingdom yet to be fully felt, there may be further pressure on volume in Europe this year. British American's balanced portfolio should allow it to capture some trading down, but we think the firm best positioned to exploit current short-term trends is Imperial Tobacco (IMT), whose stock we think still offers around 10% upside. The market has been pricing in unrealistic expectations for British American, and we still think its stock is slightly overvalued.
