Morgan Stanley turns 'incrementally more bearish' on British American Tobacco

Analysts at Morgan Stanley downgraded industry giant British American Tobacco to 'underweight' on Sunday, noting that, in its view, the threat of a "maximum nicotine policy" in the US had not been reflected in the group's share price.

The broker said that making the 'buy' case for British American was "easy", stating the firm's shares represented a "structural growth story" suffering a temporary perception setback and labelled the group as "cheap", "unloved" and offering "a great long-term entry point."

Indeed, prior to acquiring Reynolds, BAT was delivering a roughly 20% return on invested capital, generating £3.5bn of free cash flow, and while post-acquisition the analysts estimated that its ROIC had fallen to 7% and leverage had risen to around 4 times' in 2018, the business was set to generate £7bn of free cash.

"This company has consistently delivered 3-5% top-line growth, 5-8% profit growth and 8-12% EPS growth, putting it right in the top tier of the global Staples group, but the stock is on a 2020 [price-to-earnings multiple] of just 8.5x with an ~11% free cash flow yield and an ~8% dividend yield."

However, MS believed the "high impact on future profits" stemming from a potential regulation change Stateside was not "fully understood or appropriately reflected" in BAT's share price.

"In our scenario analysis we take a conservative stance on new regulation, assuming regulation to reduce nicotine to non-addictive levels takes until 2035 to come into force," said MS.

"However, even in this scenario we estimate that BAT's US profits could be as much as 50% lower and ~13% of future value at risk to the market cap."

The broker also lowered its price target on the group's shares to 2,600p based on target multiples of 7x forward earnings, implying a roughly 11% downside.

In summary, MS felt the combined risks from regulatory change, disruption/investment requirements, changing consumer behaviour and high leverage gave it more than enough cause to turn "incrementally more bearish".