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British American Tobacco (BTI), Europe’s largest tobacco company and the second-largest tobacco maker in the world, has posted solid results over the past several quarters, despite the difficult economic environment across much of the world. The company’s Global Drive Brands (Dunhill, Kent, Lucky Strike, and Pall Mall) should continue to lead the way, as these higher-priced, higher-margined products support solid earnings gains, in spite of weak overall volume growth. The company should also benefit from management’s focus on cost containment. Although British American Tobacco already has a major cost-cutting plan under way, we would not be surprised if management accelerated these efforts, or even started a new operational efficiency initiative.

Although the company’s CEO recently stated that “the recession’s impact on consumers is still with us and shows no signs of abating”, we believe that both volume and pricing should improve over the next six to 12 months. While we don’t expect a return to the strong volume growth seen more than a decade ago, which was driven by the opening up of Eastern European markets, we do think emerging market growth will help the company to offset declines in some developed countries. All told, we look for volume growth in the low single-digits over the next couple of years.

The company’s four Global Drive brands are expected to boost both top- and bottom-line results in the coming quarters. The demand for Dunhill has been particularly strong recently, and we think this trend will continue in most regions. The brand has been rolling out new products in some key markets, including Malaysia, South Korea, and Brazil. We expect sound volume gains from Pall Mall, thanks to anticipated solid demand from Germany, Pakistan, and Chile. Lucky Strike’s new product, the click-and-roll cigarette, which allows a smoker to activate a menthol capsule in the filter when the filter is clicked, is also expected to post strong sales figures. We likewise look for pricing to continue to improve in 2011, and expect higher prices in several key markets, including Russia, Japan, Indonesia, and Argentina. This should help to widen margins and improve profitability.

British American may well benefit from additional acquisitions in the near term. Recent additions, including Tekel, ST, and Bentoel, have all been successful add-ons to the company. Although the company is well diversified geographically, with no individual market accounting for more than approximately 10% of total profits, we believe new acquisitions can expand the company’s reach into newer emerging markets. These markets have become increasingly important to BTI over the years, as they currently make up roughly 75% of volume and 65% of profits.

There are some concerns, however. For one, if global economic growth stays below trend, this will no doubt inhibit people’s ability to purchase some of British American’s key products. Many consumers would not have the resources to purchase cigarettes, and some would likely downshift to cheaper, illegal alternatives. Health issues and regulatory overhang also remain concerns, although these have been present for years, and we believe many of them have already been factored into the stock’s price.

All told, we think that British American Tobacco remains a solid investment, thanks primarily to the strength of its Global Drive brands, ongoing cost-reduction initiatives, and a favorable pricing environment. The company offers a solid dividend yield, which should interest income-oriented investors. It is also a fairly stable stock, which has historically not gone through some of the wide price fluctuations that some of its competitors have experienced. However, investors should remain somewhat wary, particularly in the long run, as the risk of regulatory concerns will persist.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.