Long Thesis On British American Tobacco Amid Current Tobacco Industry Backdrop (NYSE:BTI)

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Company Overview

On Aug 23 2023, British American Tobacco [BAT for short] (NYSE:BTI) was trading below $32.5 a share with an impressive forward PE around 7 and an 8.6% dividend yield. In this article, I will demonstrate how the company possesses a robust competitive advantage and warrants a compelling buying opportunity.

Combustibles

British American Tobacco’s portfolio consists of three types of tobacco products: combustibles, traditional oral, and new categories. Combustibles contribute the most to the current income, while the new categories represent future growth. Let’s delve into them to gain a deeper understanding of the tobacco industry and BAT’s business prospects.

Combustibles are tobacco products that burn, with cigarettes being the main product in this category. This segment has been dominated by a few oligopolies for many years, which present high barriers to entry for others. These barriers include brand recognition, product addiction, economies of scale, expertise in handling regulatory challenges, and extensive global distribution networks. As a result, these companies enjoy very high operating margins. To put the 40% operating margin into perspective, consider that Apple’s operating margin has consistently been around 30%, clearly showcasing BAT’s superior pricing power.

Combustibles are highly profitable for BAT, but they also face serious challenges. Governments worldwide have implemented strict regulations on tobacco advertising, packaging, and public smoking to reduce tobacco-related harm and protect public health. These advertising bans not only hinder new competitors but also hamper the efforts of existing firms to attract new customers. Additionally, cigarettes are subject to hefty taxes in most countries as a measure to discourage usage. Most concerning of all, there has been a consistent decrease in the global smoking population for some time, with a notably sharper decline in the US. The gradual downfall of combustible cigarettes is no secret within the industry. This raises the question: Will BAT’s profits from combustibles be sustainable in the future?

To combat the shrinking number of smokers and maintain profitability, BAT and other tobacco companies have adopted a strategy of using their pricing power to increase prices. As you can see from the graph, the decline in cigarette volumes in the US is quite drastic, but price hikes have greatly mitigated the revenue loss. All this is accomplished through price increases. Furthermore, the average price of $9 for a pack of Marlboro cigarettes in the US is far from the highest in the world. It costs over $26 in Australia, over $15 in the UK, and more than $9 in many European countries. Considering that the GDP per capita in the US is higher than in these countries, there is still vast potential for price hikes.

Traditional oral tobacco is in a similar situation to combustibles. It still contributes 4% of the company’s revenue but is gradually giving way to modern oral products with less health risk.

New Categories

Let’s now look into the new categories, also referred to as next-generation products or NGPs. The new categories encompass a variety of non-combustible tobacco and nicotine products. These include e-cigarettes, heated tobacco, and modern oral products. Generally speaking, new categories are considered lower risk than traditional cigarettes, as they avoid combustion and the harmful byproducts produced when tobacco is burned. Tobacco companies may make additional health claims, but what they’re primarily concerned with is compensating for declining cigarette sales. As of 2023, BAT holds the leading position in the e-cigarette market and the second spot in both heated tobacco and modern oral products. I will explain each segment in detail.

E-cigarettes, also called vapor, are portable, battery-operated devices that heat a liquid to produce an inhalable aerosol, often referred to as vapor. Within this segment, BAT’s brand, Vuse, claims the top spot globally, including in the United States, boasting an overall segment share of 35.9% in terms of revenue.

Next, we have heated tobacco products, or THPs. These represent a novel type of product designed to heat tobacco rather than burning it outright. BAT’s brand in this segment, glo, occupies the second place, although it lags significantly behind Philip Morris (PM). Due to BAT’s initial focus on e-cigarettes, it ventured into the heated tobacco market later than its competitor. While Philip Morris sold a staggering 107 billion heated tobacco units, BAT sold a mere 24 billion units. It is surprising to see that while multinational tobacco companies fiercely compete in the rest of the world, the heated tobacco market in the US remains small. Notably, Philip Morris has thus far operated exclusively outside of the United States, a stipulation set forth upon its separation from Altria (MO) in 2008. However, the landscape is set to shift in 2024. At that time, Philip Morris will have the green light to introduce its heated tobacco products to the US market, following a $2.7 billion payment to Altria. Adding to the confusion, BAT’s former CEO, Mr. Bowles, expressed that there was no urgency to introduce glo into the US market. Given the significant proportion of revenue that the US contributes to any tobacco company, this decision is indeed perplexing. I would greatly appreciate any insights on this matter.

Lastly, modern oral products are smoke-free, oral nicotine offerings, or nicotine pouches, designed for use in the mouth. BAT’s product, Velo, also ranks second to Philip Morris globally. It leads in Europe but trails considerably in the US.

In 2022, new categories constituted 17% of the tobacco industry and are anticipated to drive the majority of its future growth. Within these new categories, e-cigarettes and heated tobacco each made up slightly less than half, while modern oral tobacco represented a much smaller proportion. It is projected that these new categories will largely fuel the drive growth of the tobacco market. Notably, global revenue for combustible products and traditional oral tobacco continues to expand, even though their volume is expected to decline.

It’s challenging to predict the profits of new categories before they mature, but I can make an educated guess based on what I know. In the 2022 conference call, BAT’s CFO stated that tobacco heating products and modern oral products had a higher profit margin than combustible ones, but the profit margin for e-cigarettes was about 50%, which is lower than that of combustibles. My explanation is that e-cigarettes can utilize synthetic nicotine produced in laboratories. This means new entrants into the market don’t need to control the tobacco leaf supply chain, unlike major tobacco companies. A case in point is Elf Bar, which capitalizes on China’s manufacturing prowess to rapidly rise as a popular e-cigarette brand. These startups respond quickly to the market and can launch a new product within days. Moreover, their relatively small size allows them to bypass certain regulations. For example, Elf Bar entered the market without FDA Premarket Tobacco Product Applications (PMTA) and sold fruit-flavored products that are banned by law. All these factors confer an additional competitive advantage. Increased competition generally leads to a squeeze on profit margins.

The situation is different for heated tobacco products, which are still made from actual tobacco leaves – a domain where multinational tobacco companies excel. The heated tobacco market is much less fragmented and is dominated by a few companies. Just like traditional cigarettes, I don’t anticipate any new players, besides the existing big tobacco companies, joining the heated tobacco competition. Consequently, the profit margins will remain high.

Valuation

To sum up, in the new categories, although still trailing behind Philip Morris, BAT surpasses other large tobacco companies in market share, with a decent profitability margin. The investment thesis for BAT rests on the belief that even if revenue doesn’t grow from this point forward, the company is significantly undervalued, given the competitive advantage or ‘moat’ of the tobacco industry. This suggests that the revenues generated by the new categories will be more than sufficient to offset the decreasing sales from traditional cigarettes.

To estimate a valuation, let’s draw a comparison with companies such as Procter & Gamble (PG) and Coca-Cola (KO), which have experienced similarly stagnant revenues in the past decade. BAT is not included in this graph because it experienced a significant revenue jump due to an acquisition in 2017. These two companies are considered consumer staples and command a price-to-earnings ratio of 25. It’s worth remembering that BAT is currently trading at a PE of 7. If it could partially close this gap and trade at a PE of 10, with the 2023 consensus per share earnings of £3.79/$4.82, the share price would be $48.2. That represents 50% price jump from here. Meanwhile, investors would receive an 8.7% dividend per year while waiting for the price to appreciate.

As an added bonus, the valuation doesn’t even take into account BAT’s 28% stake in ITC Ltd, which is the dominant tobacco company in India, in addition to its many other businesses. Based on ITC’s stock price in July 2023, this stake alone is valued at around $18 billion, equivalent to about a quarter of BAT’s market capitalization.

Another way to value BAT is by comparing it to its peers, Altria and Philip Morris. Currently, Altria has a forward price-to-earnings (P/E) ratio of less than 10, while Philip Morris International’s ratio stands at around 15. Given that Philip Morris is not exposed to the rapidly declining US market and has an advantage in the more profitable heated tobacco and modern oral segments, one could argue that it merits a premium valuation. However, this raises the question of why Altria, which operates solely in the US market and significantly lags in Next Generation Products, is trading at a higher valuation than BAT. On the other hand, BAT has only 50% exposure to the US market but ranks among the top two players in all three new category segments.

Risks

After acknowledging BAT’s significant undervaluation, let’s discuss its risks.

Firstly, the FDA plans to ban menthol cigarettes across the US in 2024, a move already undertaken by the European Union, Canada, and the state of California. To give you an idea, menthol-flavored cigarette sales account for one-third of all US cigarette sales. As bad as this sounds, historical data suggest that most menthol cigarette smokers will transition to unflavored cigarettes instead of quitting smoking altogether.

In the June 2023 trading update, CEO Tadeu Marroco estimated the U.S. volume impact to be about 13%. It’s important to note that this has already been priced in and will affect every tobacco company with a presence in the US.

The second risk is BAT’s financial leverage. In 2017, BAT took on substantial debt through its acquisition of Reynolds American. Although the company has been gradually repaying this debt, long-term obligations still total around £40 billion. This is not particularly high compared to Philip Morris. After Philip Morris’s $16 billion acquisition of Swedish Match, an oral tobacco maker, BAT and Philip Morris have similar leverage ratios. In 2022, BAT uses about 62% of its free cash flow to pay dividends and the rest for debt reduction or stock repurchases. If it stops paying dividends from now on, it could pay down the debt within 5 to 6 years. Therefore, the debt is entirely manageable.

The third risk is a change in CEO. On May 15, 2023, BAT announced the appointment of CFO Tadeu Marroco as CEO to succeed Jack Bowles. This was a surprising move since Bowles had only been in this position for 4 years, and 99% of shareholders had approved his re-election at BAT’s AGM on April 19, 2023. Tadeu Marroco stated that “there was no single event behind that decision,” but he didn’t elaborate further. The following are merely my speculations. BAT was fined $635 million by the US Department of Justice for selling tobacco to North Korea, violating sanctions. It should be clear that no individuals were charged, but Bowles was the Asia Pacific director in the early 2010s. If this is the catalyst, it’s not necessarily a negative development as it demonstrates strong corporate governance and self-discipline. Another reason could be that some aspects of the underlying business were not satisfactory, although I didn’t see obvious signs of this in the latest HY 2023 results on July, 2023 (US combustibles declined more than expected but this is industry-wide and can’t be attributed to the CEO).

Conclusion

In summary, I believe the risks mentioned do not materially alter the investment thesis for BAT. The greatest risk or uncertainty for BAT primarily hinges on the new categories. Although they are projected to be profitable by 2024 after recent investments and generate £5 billion in revenue by 2025, BAT is still playing catch-up with Philip Morris in the heated tobacco sector. Can BAT narrow the gap with Philip Morris, which already holds over 70% of the market share? Going forward, I will closely monitor BAT’s progress in this segment through future earnings reports. BAT has spent decades navigating consumer behaviors, peer competition, and regulatory scrutiny. Their deep and intricate comprehension of these factors is their core competitive advantage, which has shaped their success in the traditional cigarette market and swift adaptation to new categories. I strongly believe that this track record will continue in the future.