Business context and reporting period
British American Tobacco p.l.c. (BAT) filed its annual Form 20-F for the year ended 31 December 2017, prepared under IFRS as issued by the IASB. This is a full-year filing, not a standalone fourth-quarter report. A major comparability change was the completion of BAT’s acquisition of the remaining 57.8% of Reynolds American Inc. (RAI) on 25 July 2017; RAI’s results are consolidated only from that date.
BAT is a global tobacco and nicotine products group. Its strategy combines conventional tobacco with investment in potentially reduced-risk products, including vapour, tobacco-heating products, snus and moist snuff.
Financial performance and key metrics
| Metric | FY 2017 | Prior comparable period |
|---|---|---|
| Revenue | £20.292bn | £14.751bn in 2016 |
| Profit from operations | £6.476bn | £4.655bn in 2016 |
| Profit attributable to parent owners | £37.533bn | £4.648bn in 2016 |
| Diluted EPS | 1,830.0p | 249.2p in 2016 |
| Adjusted diluted EPS | 284.4p | 247.5p in 2016 |
| Net cash from operating activities | £5.347bn | £4.610bn in 2016 |
| Total borrowings / net debt | £49.450bn / £45.571bn | £19.495bn / £16.767bn in 2016 |
- Reported revenue increased 37.6%; adjusted organic revenue rose 2.9% at constant exchange rates. Reported operating profit increased 39.1%; adjusted organic operating profit rose 3.7% at constant rates.
- Reported operating margin was 31.9%, up 30 basis points. Adjusted operating margin increased 270 basis points to 39.9%; the adjusted organic margin rose 40 basis points.
- Reported profit and EPS were exceptionally affected by a £23.288bn deemed gain on RAI’s transition from associate to subsidiary and a £9.620bn deferred-tax credit from US tax reform. The underlying tax rate, excluding these and other adjusting effects, was 29.7%.
- Net finance costs rose to £1.094bn from £637m, reflecting acquisition financing and RAI debt consolidation. Gross interest cover was 7.8 times, compared with 12.2 times in 2016.
- Operating cash flow increased 16.0%, but cash conversion declined from 99% to 83%, reflecting, among other items, the timing of the US Master Settlement Agreement payment and acquisition-related costs. Investing activities used £18.544bn, including £17.657bn net cash for the RAI acquisition. Gross capital expenditure was £862m.
- Cash and cash equivalents were £3.291bn. The Group reported £5.4bn of undrawn committed borrowing facilities, including £600m drawn under its revolving facility at year-end. Current assets were £13.966bn and current liabilities £15.544bn.
- The 2017 dividend was stated as 195.2p per ordinary share, a 15.2% increase on 2016; the payout ratio on adjusted diluted EPS was 69%. BAT retained investment-grade ratings of Baa2 and BBB+, both with stable outlook.
Material changes versus 2016
- The RAI acquisition transformed the Group’s scale and US presence, added major cigarette, smokeless and vapour brands, and drove substantial increases in reported revenue, assets and debt. RAI contributed £4.211bn revenue from acquisition date to year-end.
- Net debt increased by £28.804bn to £45.571bn, primarily from acquisition financing and consolidation of RAI debt. Intangible assets rose to £117.785bn from £12.117bn, including acquired goodwill and trademarks.
- Operating cash flow rose despite lower cash conversion. Net investing outflow and net financing inflow were both dominated by the acquisition and its funding.
- Reported profit for the year jumped to £37.704bn from £4.839bn, but the increase is not representative of recurring earnings because of the RAI deemed gain and US tax-reform credit. Adjusted diluted EPS increased 14.9%, or 9.9% at constant rates.
- Group cigarette and tobacco-heating product volume was 686bn, up 3.2% including acquisitions but down 2.6% organically. Key-market cigarette share rose 40 basis points.
Outlook, commentary, risks and unusual items
- Management targeted NGP revenue above £1bn in 2018 and more than £5bn by 2022; it expected the NGP business to break even by end-2018 and generate substantial profit by 2022. 2017 NGP revenue was £397m, or approximately £500m on a full-year basis including RAI.
- BAT expected 2018 gross capital expenditure of approximately £1.075bn, primarily for operational infrastructure and NGP expansion. Management said it would pursue progressive deleveraging while targeting a solid investment-grade rating.
- Management cited challenging trading conditions, including excise increases, down-trading, illicit trade and transactional foreign-exchange headwinds. It also noted that global cigarette-industry volume declined by an estimated 3.5% in 2017.
- Principal risks include tighter tobacco and nicotine regulation, excise increases, illicit trade, litigation, reduced legal-market volumes, FX exposure, liquidity and leverage, and failure to develop and commercialise NGPs. NGP rules remain uneven across markets, with some bans and uncertainty over future tax and product requirements.
- Litigation remains significant. BAT disclosed numerous tobacco-related cases, including US Engle progeny litigation and Canadian provincial healthcare-recovery and class actions. Imperial Tobacco Canada’s Quebec class-action judgment was under appeal; it had posted CAD$758m in security. The Group also described Fox River environmental claims and tax disputes in Brazil, South Africa, the Netherlands and Bangladesh.
- The UK Serious Fraud Office opened an investigation in August 2017 into the Company, subsidiaries and associated persons; BAT said it was cooperating. The potential outcome and financial impact were not then assessable.
- Other unusual or potentially material items include £1.517bn of operating-profit adjusting items, including £600m of restructuring and integration costs, acquired-brand amortisation, RAI inventory fair-value adjustments and an Agrokor-related impairment. The £963m FII GLO receipt remained deferred income; the related tax litigation was unresolved.
- IFRS 15 and IFRS 9 were due to apply from 1 January 2018. BAT estimated IFRS 15 would reduce 2017 comparative revenue by £664m, with an additional £64m reduction to revenue and operating profit from payment timing; IFRS 9 was expected to reduce opening reserves by £37m.
KPMG issued an unqualified audit opinion on the consolidated IFRS financial statements.
Important facts for investors to verify
- Reconcile reported earnings to recurring performance, particularly the £23.288bn RAI deemed gain, £9.620bn US deferred-tax credit and £1.517bn of operating adjusting items.
- Review post-acquisition leverage, debt maturity and refinancing needs, cash conversion, interest cover and the pace of management’s planned deleveraging.
- Test the assumptions behind the £1bn and £5bn NGP revenue targets, the projected break-even timing, required investment and commercial adoption.
- Track developments in the SFO investigation, US and Canadian tobacco litigation, Quebec appeal and tax disputes; confirm any changes to provisions, deposits or potential exposure.
- Assess the effect of excise, regulation, illicit trade, market-volume declines and currency movements on organic revenue, margins and cash flow.
- Confirm the like-for-like impact of RAI consolidation and the 2018 adoption of IFRS 15 and IFRS 9 when comparing subsequent results.