British American Tobacco p.l.c. (BATS) Earnings Call Transcript & Summary

Hello, and welcome to the BAT Full Year 2022 Pre-Close Conference Call. Please note, this call is being recorded. [Operator Instructions] I will now hand you over to Victoria Buxton, Group Head of Investor Relations, to begin today's conference. Please go ahead.

Good morning, everybody. I'm Victoria Buxton, Head of Investor Relations. And with me this morning is Tadeu Marroco, our Finance and Transformation Director. Welcome to our 2022 second half pre-close conference call. I hope that you are all well, and I'd like to thank you for taking the time to join us this morning, which I appreciate is a very busy day. Before we begin, I need to draw your attention to the cautionary statement regarding forward-looking statements as well as to the note and disclaimer contained in the trading update. I will now hand you over to Tadeu who will share a few words on current trading before opening it up to questions. Unless stated otherwise, our comments will focus on constant currency adjusted measures and all share data is year-to-date average to September 2022.

Thank you, Victoria. Good morning, everyone, and welcome. We are delighted to report this morning that we continue to accelerate our transformation and pace towards a better tomorrow. There are three key message we would like to highlight to you. First, our new category business is becoming a significant contributor to group performance and is driving our faster transformation. Second, we are navigating growing macroeconomic pressures in the second half enabled by our increased agility, resilience and bundle savings. We expect to deliver strong adjusted operating margin improvement in 2022. And third, we are confident in delivering our full year guidance. Start with our New Category business. We added a further 1.1 million added consumers of noncombustible products in Q3, should reach 21.5 million and continue to grow. Our New Category products are now available in over 60 countries globally with around 90 country category market combinations. This is driving strong revenue and volume growth, supported by continued market share gains in key markets. We are also making excellent progress reducing New Category losses, and expect a growing contribution across all New Categories and regions for the full year. Our progress is driven by increasing scale, leading to operating leverage and further automation reducing cost of goods sold. In addition, our growing brand equity has enabled us to increase pricing on both devices and consumables. We are confident in delivering on our targets of GBP 5 billion new category revenue and profitability by 2025, and 50 million added consumers of our noncombustible products by 2030. We continue to expand and invest in our New Category business with exciting innovations and further geographic expansion in the second half. Our new glo device Hyper X2 is now rolling out in 19 markets, following a nationwide launch in Japan in October. Glo Hyper X2 is a further step towards delivering [indiscernible] product experience with a smaller, lighter device and dedicated boost button for maximum [ taste ] satisfaction, and is delivering positive early results. In fact, we have been rapidly rolling out our new disposable product, Vuse Go. In our early launch Markets Day U.K. and France, Vuse Go is ranked #2 in the disposable segment with premium price position volumes, which are accretive to our ePort platform. Having rapidly rolling out Vuse Go over the second half through our broad distribution footprint and consumer reach. It is clear that the disposable segment is that separating the growth of the [ Vuse Go ] category overall, convenient and flexible formats to encourage further switching for existing smokers. Our well embedded responsible marketing practice remains as important as ever with a strict age verification process embedded through training and monitoring, alongside bad schemes and recycled solutions. As our organization continues to transform its speed driven by New Categories, we continue to embed ESG across the organization, and we are accelerating on our ESG ambitions and targets. I'm delighted that in September, we appointed Mike Nightingale, who many of you will know as our first Chief Sustainability Officer to lead our sustainability and the ESG agenda. Recent highlights include our race to zero commitment, which is embodied in our low carbon transition plan published in September and further demonstrating our commitment to halve absolute emissions across the value chain by 2030 and to be net zero year by 2050 at the latest. And achieving another Alliance for Water Stewardship certification at our largest U.S. manufacturing facility as we progress towards 100% group certification by 2025. Moving on to group performance. We expect to deliver strong adjusted operating margin improvement for the full year despite increasing inflation in our supply chain through the second half. This has been made possible through the scale of our brands, and increasingly focusing on our market investments supported by robust pricing. In addition, the annualized savings of our 3-year Quantum program are expect to be in excess of GBP 1.5 billion by the year-end. Looking forward, we expect the growing impact of inflation on our supply chain to continue. We're focused on mitigating this through our scale supply chain agility, in addition to our ongoing focus on driving efficiency gains throughout the business. Our business remains highly cash generative, and we expect another year of operating cash conversion well ahead of our [ financial ] targets. While expecting net finance costs to increase given the recent speed and significance of global interest rates rise and currency volatility, we will benefit from a 90% fixed debt profile and an average maturity of over 10 years. Altogether, our business transformation is accelerating, and although not immune to growing macroeconomic pressures, we believe we are well position to navigate these and are confident in delivering on our full year guidance. In line with our active capital allocation framework, we are on track to return GBP 2 billion to shareholders through our share buyback program in 2022, demonstrating our commitment to the differing enhanced long-term value for shareholders. Alongside share buybacks, our framework also includes our progressive dividend policy with growth in sterling terms and a medium to long-term payout ratio target of 65%, maintaining our leverage within our target corridor of 2x to 3x adjusted net debt to adjusted EBITDA, whilst also considering potential both on M&A opportunities. As we said in February, the Board will review these capital allocation opportunities annually while taking into account the macroeconomic environment and potential regulatory and litigation outcomes. Applying current exchange rates to the year-end, we expect our leverage to be within our 2x to 3x adjusted net debt to adjusted EBITDA corridor -- at the higher end. Looking forward, given the significance of global interest rate rise and currency volatility, we will aim to reduce leverage towards the middle of this corridor over the medium term to further support the long-term strength of our business. Turning now to our category performance in detail. As a reminder, our market shares are average year-to-date September versus full year 2021. Our transformation is accelerating with Vuse continue to extend leadership globally in the fast-growing Vapour category, achieving 35.7% value share in key Vapour markets, up 2.2 percentage points. In the U.S., the largest global Vapour market, Vuse continues to strengthen its #1 position, reaching 39.3% value share, up 6.8 percentage points with leadership in 35 states. In addition to our rapid geographic rollout of Vuse Go, Vuse ePod 2+ our first connected device is performing very well in Canada while it now represents 72% of all sales in tracked channels. In THP, the continued momentum of glo Hyper in Europe drove category volume share in key THP markets, up 1.6 percentage points to reach 19.5%. In Japan, growth volume share of the total nicotine market reached 7.3%, up 50 basis points as smokers continue to switch to THP. In a highly competitive market, our THP category volume share was 20.2%, down 1 percentage point in September. This was ahead of the national rollout of Hyper X2 in October, which is delivering positive early results. Glo continued to grow category volume share across all European markets with aggregate category share in key THP markets reaching 20.4%, up 4 percentage points. Turning to Modern Oral. In Europe, we remain the key market leaders in 50 Modern Oral markets with aggregate European volume share broadly stable at 69.1%. Our European leadership is driven by Velo brand equity and the success of our innovation pipeline, including mini pouches and MAX ranges. As the Modern Oral category continues to grow and become more established in Europe, we are seeing a strong growth in average day-to-day consumption. In the U.S., we have submitted the PMTA for a superior field of product. We are particularly proud of Velo performance in Pakistan, now our third largest Modern Oral markets where we have rapidly achieved national coverage. Enabled by powerful consumer-centric digital activations, Velo has reached a monthly volume of over 40 million patches. This progress demonstrates our ability to unlock the significant opportunities for Modern Oral in emerging markets. In combustibles, full year global tobacco interest volumes are expected to be down around 2% versus our previous guidance of around 3%, driven by continued post-COVID recovered in emerging markets. Group value share is flat with gains in the U.S. and -- offset by declines in AMSSA and Europe. We expect our target portfolio of brands across price tiers to deliver a robust financial performance across AMSSA in Europe, driven by resilient volumes. While our [ AMSSA ] performance will also reflect the impact of the sale of our business in [ Iran ] in August last year. In the U.S., industry volumes remain under pressure in the second half due to the growing macroeconomic headwinds and post-COVID normalization of consumption patches. In addition, our revenue performance will reflect the [ outlines ] of the prior year inventory of around GBP 200 million. Another to offset early signs of accelerated downtrading in the U.S. industry in the second half, we have recently activated commercial plans across specific brands, channels and states. Overall, pricing has remained strong, partially offset by many geographic mix. In conclusion, it's clear that we are building strong momentum, and our better tomorrow transformation is accelerating, which will support a sustainable growing business. We added even on our three strategic priorities driving a step change in New Categories, value through combustibles and simplifying the business through Quantum. Leveraging our increased agility and resilience to combat growing macroeconomic pressures in the second half, we are confident in delivering our full year guidance of 2% to 4% constant currency revenue growth and mid-single figure adjusted diluted EPS growth while absorbing a transactional FX headwind of around 2%. Thank you, and I will now open the call to questions.

[Operator Instructions] And our first question today comes from Nik Oliver of UBS.

Just two from me. I guess one on U.S. volumes as we're now coming out of the COVID bumps. I guess as we look into 2023, is there any reason that we should expect industry volumes to move back to the old kind of down 4% to 5% trajectory? So that was question one. And then question two, and today, you sort of touched on this on capital allocation, but it's a question that we get asked a lot and obviously, the buyback this year was taken very well as we move into next year. Just any thoughts you can give investors on how you're thinking about the capital allocation into next year? I mean looking at visible alpha, I think most people have about GBP 2 billion of buyback in their forecast. But anything that you could share that would be super helpful as well.

Okay, Nik, thank you for the question. Starting with the U.S., I think that's a -- we have to -- let's take a step back and make an assessment of what's happening in the U.S. over the last few years. If you go back to 2020, we had actually an increase in volumes in the U.S. clearly, as a consequence of the change in consumer partners at the back of COVID. We have a more normalized '21 and a more depressed '22. If you take an average, at least actually middle of this year, wouldn't be much dissimilar of the secular decline of 4% to 5% in the U.S. market when we average out those three periods. But what we have seen more recently in the second half of the year is basically a bit more of a pressure due to this continued post-COVID normalization of consumer patterns, and the growing macroeconomic pressures is starting to impact consumer disposable income. So you saw, for example, gas price at a certain stage, reached a big. And this all has -- we note that there is a big correlation between that and the sales of cigarettes in the U.S. And as a result, we saw also some consumers shift to specific channels like discount and dollars in some states with early signs of a down trade at industry level. On the other hand, we note that the U.S. market has a very high level of employment, so very low unemployment rates. The gas price that I mentioned before that has reached a peak now starting to level off. And as we mentioned in our trade update today, we are -- we have recently activated commercial plans with much more continuous deployment of our revenue growth management capabilities in a more increased target and granular way, more target discount problems. So we are well placed to navigate through that. But the U.S. markets, as we saw up to the mid of the year, will not be that much dissimilar for the full year. We are not providing any guidance. We -- it's difficult to talk about '23 because of these contradictory dynamics from one side, the macroeconomic pressures from the other side, consumers in full employment, gas pricing coming down. But we expect industry volumes to improve in 2023. So this, combined with -- and a combination of our commercial activities, we'll probably improve our performance next year from the second half of the year. So our perform probably will be more weighted in the second half of the year. Looking the long term, we are not seeing any material change in terms of [ middle-term ] elasticities in the U.S. We believe that the U.S. remains very profitable, and highly profit and attractive FMC markets with elasticity well below the average at the group level, in the global level, and affordability second highest globally. And this puts us in a very strong position to continue to drive value in combustible to fund our transformation. The other point that I would like to highlight about the U.S. is our excellent performance in Vapour. This has really become more and more significant not just at the group level, like I mentioned before, but also in the U.S., in particular. All the inroads that we are making not just on the top line of our Vapour business in the U.S., but also in the bottom line with activity in all the levers that we have mentioned before in terms of COGS through automation, through change in footprint that's reducing [indiscernible]. The fact that we have taken less discount, taking more pricing, the revenue growth management being deployed also in Vapour. So there's a lot of initiatives being put in place, which we are very pleased with. That has resulted in very improving margins and enhanced profitability in our Vapour business in the U.S. So puts us in a very strong position moving forward. In terms of your second question, which is around capital allocation, well, we -- early this year, we clearly lay out that's our new active capital allocation framework. We will be always about us defining every early stage in the year between the four basically priorities to deploy our free cash flow. The first one is a growing dividend with this medium- to long-term payout ratio target of 65%. The second one is paying down debt to reduce our leverage and be in the corridor. And if anything, the fact that now we have a higher global interest rates. That is a change in what happened since the beginning of the year. We will be aiming, like I said, in my statement to get us to in the medium term towards the middle of this range of 3 to 2. And we also want to do -- some bolt-ons M&A. We are not expecting anything more significant in that space. It will be pretty much what you have had seen over the last couple of years using our corporate venture capital and creating some foundations, mainly of the beyond inverting space. And we have the share buyback that I agree with you, was very successful. The reintroduction of share buyback, BAT has always some value on that. And that's the reason why it's part of our active capital allocation. So the Board will evaluate this capital allocation priority on the beginning of next year as it will be doing on an annual basis, and we will take into consideration future potential regulatory impacts. For instance, from time to time, some of you asked me about various legal case like DOJ, you know that we have provided for that. It's difficult. I don't have any update at this point in time. But clearly, you have to take into consideration at certain stage that there will be some cash outlay. So that will see them away. I'm not saying that anything is coming in the short term, but these are the factors that we have to take into consideration together with macroeconomics and making a final call, and we'll be doing that at the beginning of the year. And then we're going to stipulate clearly what will be the programs for next year.

We now move on to our next question, which is from Richard Felton of Goldman Sachs.

My first question is you reiterated your guidance in the mid-single-digit constant currency EPS growth this year. Could you just remind us how much impact you're expecting from Russia within that? I appreciate there's lots of complexity involved in transferring your Russia business. But could you perhaps give us an update on where you are in that process. Should we still have Russia in our estimates for FY '23? That's my first question. My second one, I mean, you're talking to the accelerated down-trading trends that you're seeing in the U.S. Did that change the way that you're thinking about your overall pricing strategy in the U.S. in the near term? And then secondly, you've called out some of the activations and specific things you're doing on certain brands and at the state level. Could you maybe give us a little bit more color on sort of what that actually means and what that is in practice?

Yes. Thank you, Richard. Look, starting with the U.S. We -- as I said, we see a lot of pricing potential in the U.S. I don't think necessarily that we'll be seeing change in the path on the pricing, but we will need to be much more targeted in terms of how we deploy revenue growth management. So we have a portfolio, which is pretty skewed to us, the premium. So we get a bit more subject to this movement of consumers and we have to act accordingly. So I think the point is less about our ability to take pricing. It's more about with taking price and being able to recognize some consumer shifting partners like these stores of discounts or some states, and having a kind of problem that could cope with that. Some target discount in some individual place, so we can support our brands better in that environment. Until it lasts, it's difficult to understand exactly the dynamic. Like I said, there is -- and you are probably following this very closely as well. There is speculation that the inflation has already peaked. And then the question is how fast we will take it to bring it down. The fact that we have the oil price now coming to more reasonable levels than the early in the year. So all those things, the full employment that would be very helpful, would be supported for consumer purchase power. And we accordingly, adjust our activities in the market accordingly. The pricing power of the U.S. is massive, and I don't think that this will necessarily change as a consequence of that. So that's the U.S. view. On the -- on Russia, this is an unpremised [indiscernible] complex process with many moving parts, as you can imagine. We are working as fast as possible to make sure that we transfer a viable business. And why I'm saying that because we have a massive operation in Russia. We have not just the head offices in Moscow, but we have 75 regional offices, manufacturing facilities on Petersburg, which employ around 2,500 people. So -- and we are, for sure, focused on supporting our employees and safeguarding the employment. So prior to the conflict you know that we have rolled out TaO, which is the SAP systems that we have across the group. And our full Russia operations were fully integrated into the group across all areas of the business and systems include the supply chain, marketing report, and [ IT ]. So this means -- what is this? This means that we have now to extract in Russia as a stand-alone business, and this is incredibly complex. On the IT side, you can imagine how it takes -- how long it takes. And we are in negotiations to get the best deal for different stakeholders, including the employees of the company. And so difficult to precise the [ timing ] on that. And I think that we talk before when we announced the relevance of Russia in our numbers in terms of [ 3% ] of revenue and 1% of [indiscernible] in terms of profit. And we -- I just want to remind you, until we transfer the business, we need to continue accounting for that in our numbers, consolidating in line with IFRS accounting rules. And that's the reason why we -- when we provide the guidance more early in the year, we said the guidance, irrespective of the timing of Russia, but it's something that is not completely under our control, but there are a lot of moving parts at this point in time.

And up next, we have Gaurav Jain of Barclays.

So three questions from me. One is on this midterm leverage ambition of 2.5x, is that our ambition for FY '23 or FY '25? And if you could also just remind me that in your leverage calculation, you do not really put ITC's equity income or dividend in the denominator, right?

Gaurav, the 20 -- the medium term is -- it's basically the X couple of years. It's not a '23 EBITDA -- I'm not providing any '23 targets yet. That's why we are considering this as a midterm. It's a -- we need to consistently continue deleveraging the company, and we believe that with the scenario that we have currently with the higher interest rates that we'll be in better place in the middle of the current than we are now at the high end of the range like we spoke before. And -- because it [ dip ] puts us in a very volatile position because you know the dynamic of exchange rates, 31st of December, when you get translating -- all the translation of your debt in a single period of time. So we want to be in a more comfortable position, and we want to reduce the levels of debt as well because of the high levels of interest rates now. So when we calculate that, yes, you are right, we are not taking. The ITC is part of our assets in a way, but we are not making any further deconsolidation of ITC in this calculation.

Sure. Because I think S&P actually puts it in the denominator. So that's something, which I just thought I would highlight. Then the second thing I had is on this -- on the California flavor ban, which will come in 2 weeks. How should we think about it?

Well, look, the California flavor ban would be, if anything, an interesting experience, I would say, because we -- there is always this question about menthol ban coming through in the U.S. What happens, and with the level of exposure BAT has in the U.S., we always try to cut back and make analogies of what has happened in other markets in terms of Canada, in terms of Turkey more recently, but also Europe. And what we have seen in all those markets is that consumers, they smoke first, and they are very loyal to their brands and not necessarily for a menthol or no menthol. So the level of retention in those markets that have implemented the menthol ban is still very high, and that's why we were not always in agreement towards these views of levels of exposure to high and so on and so forth. So I think that the California experience, given the fact that it's a large state, different from other small states that has already implemented menthol ban in the U.S. But California is large enough for us to have a [ menthol ] reading. So I think that in the way, this could be an interesting experience to go through. We -- I think BAT is well settled for that. And between the cigarettes, and the fact that we are now more and more present and dominating now the Vapour markets, gives also some [ flags ] whenever those policy coming through. We still believe that's not the right policy for the government to pursue. Because based on the experience that we saw in other markets that I just referred to, this is not addressing the purpose that the government had in mind when they put these in place. And the tobacco harm reduction agenda is much more effective and efficient to deal with that and -- other than to implement those types of policies. So I think that what we'll be seeing in California will be pretty much confirmation of what we have seen in the other parts of the world.

Sure. And my last question is again on the U.S. So clearly, in 2H, you will have a pretty meaningful volume decline in cigarettes, but then your e-cigarette profitability would also be going up. And in a way, it's a very interesting crossover point, which potentially can answer the question that do -- can NGP growth offset decline in combustible. So my question is that in 2H '22, will your U.S. EBIT be growing over 2H '21?

You have -- if the U.S. beat...

Yes, the profits in the U.S. Will you still be growing your U.S. EBIT in 2H '22 over 2H '21 because e-cigarette growth offset cigarette decline?

Yes. Look, we haven't finished the year Gaurav. So we don't want to talk specifically about markets there. But there is -- the point that I make about the Vapour category in the U.S. is really getting more meaningful in terms of contribution. And this -- and I'm talking about the U.S., but I'm making across to the whole group. And that's why I start with my first point about the comments of the statements and the message that I want to give to all of you is that New Categories, and as we said before, is getting more and more meaningful in terms of the group performance. When I mean group performance, I include definitely the group financials, revenue and the bottom line. The reduction of losses in the case of the total group, and you have been following this closely, is accretive for the group. So since 2021, that was the first year, that's why we called pivotal year where we had a reduction of GBP 100 million in terms of loss, and we presented the numbers in the half year of 2022. You saw that we could progress even further. And what I'm telling you now that for the full year, we're expecting this trend to continue and will be a strong part of our group performance moving forward, as we said and we have always said in the past.

[Operator Instructions] We're now moving on to a question from Rashad Kawan of Morgan Stanley.

Just a couple of quick questions from me. The first one, there was news a few weeks ago that you withdrew MRTP applications for some of your smokeless portfolio in the U.S. Can you give more detail as to what happened there and your thought process going forward? And then the second question is, do you have an outlook for U.S. industry -- cigarette industry volumes for this year?

Yes, well I see there is [indiscernible], that we are not providing guidance for the industry itself. What we saw -- but what I can tell you is when we came to the half year, we had a decline. I think that was around 9% at that time, and we were having an expectation that the situation would get better in the second half because of more benign comparator. And what we have seen so far is that despite the fact that we have a more benign comparator, we have this macroeconomics weighting more in the second half of the year. So I would leave you there, okay? So we are not providing any guidance on that, but this can give you a kind of a reference first, what you have been seeing in terms of tracking size markets and so on. Our -- the withdrawal of -- is basically on our those products, and this is basically related to portfolio prioritization.

And we move to a further question now from Simon Hales of Citi.

Just a couple of points of clarification, please. Sorry to belabor the point to come back to the buyback and medium-term leverage targets again. But I just want to make sure I'm clear on the go-forward messaging there. If I look at consensus today, the consensus has your net debt-to-EBITDA ratio getting into that middle of the target range by 2024, and that's despite an ongoing GBP 2 billion a year of share buyback assumption. It sounds like you've said today you're comfortable with that time frame. The first question to ask is, am I reading that correctly? And just secondly, to clarify, when you calculate your leverage ratio, are you basing it on year-end FX rates, i.e., spot? Or are you making any adjustment for average moves in FX during the year?

Okay. So just to be clear on the ratio, we calculate all the debt and the balance sheet based on the 31st of December ratio and all the earnings throughout the year. So if there is a mismatch between the average rates, FX throughout the year, and the 31st of December, you'll reflect this in the ratio. That's why we are so subject to this FX position. So when I talk about our expectation to be at the high end of the range this year is assuming the current FX position. And the fact the matter for the debt side. It's more the dollar to the pound because the 7% of our debt is dollar-denominated. So I just want to make this point quite clear for those that are in doubt about. So in terms of the consensus, I cannot comment much on consensus. What the point that I'm making here is that every single year, the Board will make an assessment about all the macroeconomics that we have been, and all the litigation case that we have to consider when we make assessments in terms of how we prioritize the allocation of our free cash flow. So a lot of you asked me about, for example, the DOJ case. We provided for the DOJ case. I don't have any news on that case, but at least you have a number there ready to have as a reference in terms of provision. And these are the type of things that we have to consider. The Canada WCWA, you also have the position set of cash that we have basically trapped in Canada, which is part of those ratios at this point in time. We had to make consideration in terms of what is the likely scenario for us to have -- to come to a settlement and what happen with the cash. So these are things that on a yearly basis, we'll be sitting with the Board and making further considerations. So the fact that we want to get to the middle of the range is more assertive now given the change in terms of the circumstance of the interest rates. The interest rates, as you know, has increased unprecedented level in terms of pace over the last 6 months, and we have to take this into consideration. And hence, our determination to get to the middle of the range. So that's more or less what I'm trying to convene as a message. And I'm not trying to make any type of anticipations of the capital -- but this is a discussion that we are due to have anyway in the year-end results announcement in Feb.

As there currently no further questions, I would now like to hand the call back over to you Tadeu, for any additional or closing remarks.

So thank you all for this, and for your questions. I would like to leave with you with a few final comments. We are now in a period of faster transformation with our well-established multi-category strategy, strong portfolio of global brands and our resilient highly cash-generative business. This will enable us to further invest in and accelerate the transformation of our business as we continue to build a better tomorrow. And with that, I look forward to update you further on our transformation at our full year 2022 results presentation on February 9. Thank you very much.

Thank you for joining today's call. You may now disconnect.