Fool's Eye View

[ March 7, 2000 ]

BAT Keeps On Puffing

By Maynard Paton (TMFMayn)

Carburton Street, London -- Firstly, a quick rant. I can't stand cigarettes. With that awful stench and the likelihood of permanently damaging your health, I'm surprised smoking is still such a popular activity. As a non-smoker, the thought of stinking like an ashtray, with my chances of catching lung cancer enhanced, doesn't appeal. But that's the real world.

In the investment world, things are slightly different. You see, up until a few years ago, cigarette manufacturers had it easy. In fact, it was one of the best industries to be in. The products were addictive, and were bought daily by the hooked customers. And with the customers being creatures of habit, they rarely changed to any rival brand. No huge expenditure has ever been needed for any research and development purposes to develop a new cigarette. So without any R&D, there has never been a revolutionary development in the tobacco industry that necessitated all the manufacturing equipment being replaced either. And even the government has given profits a helping hand too, with the tobacco industry saving money from the ban on expensive advertising on television.

Just as long as your customers stayed hooked, increased profits could be generated by raising the price of a packet of cigarettes, while keeping a lid on your corporate costs. As your customers were addicted, they just kept on paying the higher price. With minimal reinvestment expenditure, any tobacco company was a veritable cash cow and a great business.

And all those characteristics are still true today. Unfortunately the party couldn't last. Greedy American lawyers have got wind of the enormous bags of cash sat in every cigarette manufacturer's bank vault, and have instigated extensive litigation against the tobacco industry, claiming enormous smoking-related damages on behalf of their clients.

And so we lead on to British American Tobacco (LSE: BATS), the largest of the three UK tobacco players, which reported full-year results today. Aided by the merger with Rothmans, BAT announced that revenues had jumped 24% to £21.7b and pre-exceptional operating profits increased 30% to £2.0b.

But nowadays, what really counts is the dividend. With the threat of a big litigation payout still looming, unless you're punting on the legal threats being dismissed any time soon, any investment in BAT really should be with "income" in mind. The full year dividend came in at 26.2p. With the current gloomy share price at 282p, this equates to a dividend yield of 9.3%. Very nice.

What are the chances of any substantial, successful litigation against Brown & Williamson, BAT's American subsidiary? Well, if you believe BAT, very small. Martin Broughton, Chairman, remarked today on the current class action in Florida: "It has fundamental flaws. In particular, the proposals conflict with the established principles of good public policy formations and risks undermining governments' sovereignty over tobacco regulations and excise." He also adds: "Because of the way the class action is being run by the Judge, who is himself a member of the class, investors expect a headline-grabbing punitive damages award in the next month or so. Despite the blatant pressure by the Judge, Brown & Williamson have no intention of settling."

The company also stresses that the one current legal battle in trial is an exception, as other lawsuits are continually being dismissed despite "increasingly novel claims being filed, not least by the US Federal Government". Indeed BAT takes a sideswipe at the "creative" lawyers who persuade other countries to bring their claims to the, potentially more rewarding, US courts. But BAT still have 537 cases pending against them...

After a rather lengthy Contingent Liabilities section, the Directors sum up their feelings thus: "(We) do not believe that the ultimate outcome of all this litigation will significantly impair the financial condition of the group". Well, all right, they would say that, wouldn't they?

But what of the dividend? Can that be maintained? Looking at the cash flow for BAT, there is still plenty in the tank for dividends to be sustained at the current level. After interest, tax and capital expenditure, BAT had £1,264m in free cash. £530m was spent in dividends in 1999, with another £216m on small acquisitions. This leaves £518m of excess cash. As I said before: what a great business.

With no end of smokers queuing up for their piece of the legal action, it's unlikely the cloud will be lifted from the BAT share price in the near future. But just as long as BAT can drag out the sole current class action, continue to stub out the other cases against them, and their existing customers keep on puffing, then the level of dividend looks pretty secure for those who seek a high yield.

Related Links
• Fool's Eye View discussion board
• British American Tobacco discussion board