Contingent liabilities take the shine off BAT

THE ink on yesterday’s Business Day was barely dry when I was asked this morning via e-mail, how I would rate the shares of British American Tobacco (BAT) as a long-term investment if the company was not in tobacco, but, say, in retail.

“It seems to me,” the reader goes on, “that you don’t like BAT because you’re antismoking. Your view on the share is subjective. As you keep on saying, look at its investment fundamentals. That’s why I have BAT shares.”

The reader has a point: I won’t invest in BAT because I don’t like what it does and so I won’t invest in its shares. On the face of it, though, BAT appears to be fundamentally in good shape to produce long-term bottom-line earnings per share. In addition it has an exceptionally generous dividend policy pay-out of 65% of bottom-line earnings.

Based on the figures for the financial year to December 31 2008, the company’s return on assets managed was sound. Revenue before duties, excise and other taxes on its sales were £33,92bn, and total assets at the end of the year were £27,55bn. Its asset ratio was, therefore, enviable at 1,23.

Earnings before interest and tax amounted to £ 3,68bn and its return on sales, the operating margin, was 10,86%. The return of assets — the product of asset turn and operating margin — was, therefore, 13,37%. The pure rate of equity — the product of the ratio of assets to equity and the return on assets managed — was 51%.

BAT also reports revenue after deduction of duties, excise and other taxes. This reduced revenues for the year to £ 12,12bn. On this basis the asset turn reduced to 0,44 and the operating margin correspondingly improved to 30,39%. The return on assets managed and the return on equity were both unchanged.

There is at least one conclusion you can easily draw from the two models: While higher duties and excises push up the prices of its products, these higher prices do not significantly discourage consumers from buying. So the company has considerable flexibility to manage its sales margin. In friendly markets — countries that don’t have punitive taxes on its products — it can offer its products at attractively low prices. In countries that try to discourage sales of its products, it can rely on inelastic demand — the addiction effect — to maintain sales. But then, I guess, food retailers enjoy a similar inelastic demand when prices rise. People have to eat.

BAT’s market ratings have not changed since yesterday. Its share price is around R230 giving it an historic earnings yield of 7,55% and a dividend yield of 3,83%. Its price-earnings ratio of more than 13 tells us that the market is expecting bottom-line earnings per share growth of 20% or better.

BAT’s markets will more probably expand rather than contract. Its operating assets are being streamlined. It has the resources to continue litigation related to the effects of its products.

Before you are tempted to buy the shares, however, read the nine pages on contingent liabilities and financial commitments in note 30 of the 2008 annual financial accounts.

It is a terrifying horror story, and its possible financial implications on future earnings are not quantified.


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