City chokes on BAT's profit fall and warning

BRITISH AMERICAN Tobacco, the world's second-largest cigarette maker, yesterday surprised the market with a drop in 1998 profits and a warning over trading in the first part of this year.

The producer of Lucky Strike cigarettes said tough conditions in Asia, Brazil and the US - three key markets - will slash operating profits in the first quarter of 1999. The warning caused a drop in BAT's shares, which by 2.5 per cent to 557.5p.

Martin Broughton, the chairman, admitted that the economic troubles in Asia and Brazil hampered sales in the last part of 1998 and were likely to continue in the first quarter. The emerging market woes were compounded by a fierce price war in the US market, where Brown & Williamson, BAT's American subsidiary, has a share of around 15 per cent. "The reality is that operating profit is unlikely to match the same period last year," when BAT posted a pounds 378m result, said Mr Broughton.

His comments came as BAT, which last year agreed to buy rival group Rothmans for pounds 4.6bn, unveiled a 16 per cent drop in 1998 pre-tax profits to pounds 738m on sales down by 1.7 per cent to pounds 14.6bn. The figures, the first since the demerger of its Allied Zurich insurance operations, were hit badly by the cost of settling tobacco litigation in the US; BAT had to pay pounds 613m as part of the settlement of the landmark Medicaid legal case between cigarette manufacturers and US states.

The spectre of hefty legal costs is the main worry for BAT's investors. US manufacturers will have to pay more than $200bn (pounds 125bn) in the next 25 years to compensate smokers in the Medicaid case alone, and BAT is likely to be one of the main contributors. Next year, the company is expecting a $1bn legal bill.

Supporters claim the settlement of the US case is positive for the shares as it removes a major uncertainty. "We believe the litigation scene is much less daunting than it was a year ago," Michael Prideaux, a BAT director, said. But the company is still involved in more than 600 cases, including a potentially large health insurers' suit opening in Ohio this month. An analyst said: "The outcome of legal cases will be the dominant element for the shares for years to come."

On the trading side, BAT's acquisition of Rothmans should boost the group's European presence and help it diversify away from the mature US market. The acquisition, set to generate a pounds 5bn goodwill bill, will help to cushion the peaks and troughs of cigarette sales in emerging markets.

However, some analysts are sceptical about a near-term turnaround and were downgrading 1999 earnings. "It's clearly going to take a year or two for their earnings growth to get back on track," said one.

After yesterday's events, the shares trade on around 11 times 1999 earnings - a justified discount to UK producers such as Gallaher and Imperial Tobacco, given their more limited exposure to litigation.