Apr 18, 2023·edited Apr 18, 2023Liked by Devin LaSarre
Wonderful write-up! A quick question on the valuation methodology used in your DDM with Exit Multiple. I noticed that you strip out adjusting items from terminal EV then discount to PV whereas, to my knowledge, common consensus is discount terminal EV THEN strip our adjusting items to get PV of Equity (otherwise you would be double discounting the debt and cash). Perhaps I'm just naive to this specific modeling technique as my DDMs typically gets capped by a perpetuity TV and, truthfully, I'm partial to FCFF models where I'm significantly more comfortable. I notice that were you to compare FMV using these two TV methods you end up with a near $20 intrinsic valuation differential due to the significance of debt on the valuation. It would be extremely helpful to understand your thought process in deriving PV of Equity!
James, thank you for the thoughtful comment and question! I'm right there with you: I feel more comfortable calculating unlevered FCFF DCF models and have included such in multiple pieces. Nonetheless, I try to chop it up and look at each company from various perspectives.
In an unlevered model, as you said, we discount EV back to PV and factor in cash, debt, investments, etc. to get an equity value. Such an approach does not explicitly assume how cashflows are distributed. In a levered version, we're granular with such things. The 10-y exit model assumes debt/cash/etc. is constant until the exit period and is a snippet of much larger and more grotesque calculations. In them, I'm approximating the firm's ability to convert EBITDA to FCFE. Not wise to do unless you have a relatively mature business with a relatively predictable footprint and D&A. Part of that conversion ratio is also a function of the (I) of the debt through time. There is also a margin of safety in the conversion ratio. In other levered approaches, you can model how rates/rolling debt/retiring debt can affect (I) and thus the EBITDA/FCFE conversion. Additionally, we're discounting the equity value by the CoE, which is markedly higher than the WACC we'd use to discount the EV. You can adjust for these differences in an unlevered DCF and produce similar results.
Is this pretty? Very much no. But I'm pretty vocal about modeling and prefer roughly painting ideas through numbers rather than attempting to gain a false sense of precision. Rates, multiple, FX, execution of operations, regulation, etc. can (and probably will) result in a future that looks a fair bit different than illustrated. The aim is to be directionally correct and conservative enough that it works in one's favor.
I hope this clarifies the approach. I'll consider switching it up in future posts to present additional angles. Thanks again for the great question.
Thank you for this detailed answer! This was extremely helpful in understanding the modeling decisions. As mentioned in my original post, these write-ups are amazing well put together. Truly a great resource in evaluating the tobacco industry as a whole.
Thanks for the detailed article. All is not well between BAT and ITC ( Indian associate). BAT is against to unrelated diversification whereas ITC is going ahead with it. BAT infact stopped ITC to issue new ESOPs so as to stop diluting its stake in ITC. So your assumption that BAT can influence policy in India through ITC is something to take a conservative view on unless BAT explicitly mentioned the same with solid backing.
Great point. Thanks for your input. I agree that the relationship (and India's market broadly) are more complex. My conservatism is expressed by fully discounting the equity investment in the valuation. While it may not be smooth sailing, the stake is most certainly worth more than 0 - and probably quite a bit more at that!
Just an update : ITC is investing in pure nicotine production facility. The facility is being geared to manufacture purest nicotine derivatives conforming to US and EU pharmacopoeia standards. Looks like they shall export the same. As per my limited understanding derived from reading ur detailed blog posts, I am guessing that these nicotine derivatives may be used in nicotine pouches / those reduced risk products which are the current most happening products in tobacco world. This may help ITC also when these kind of products are allowed in India. I believe ultimately Indian Govt shall allow these reduced risk products ( no idea when this shall happen though) as the entire world is moving towards reduced risk products. Phillip morris though the leader through products like IQOS is having limited presence in India through Godfrey Phillips in which they have 25% stake. But the promoters of Godfrey Phillips are not trust worthy and have questionable track record. BAT through its two associates like ITC and VST is on a better footing in India for sure.
A good deal of the industry is working behind the scenes to head down a similar path. PMI has Vectura Fertin. BAT has its own operations similar to Fertin. It will be very interesting to see how it unfolds. Thanks so much for your input, Sunil.
The CR date was fixed. M/D was indeed flipped. Wonderful catch, thank you.
Regarding disputes - I am nothing close to a patent law expert, so must defer to others. Alto PMTA is still under review, so not far-fetched to think BAT pushes MGO products to fill potential void while iterating future versions that skirt specific patents.
For the U.S. space specifically, I'm much more interested in following if/when the FDA will begin to enforce against smaller participants and if we will see meaningful changes in approach to synthetic nicotine. This would undoubtedly impact a huge % of the fragmented market; especially the growing disposable subsegment.
My broader thesis revolves around the fact that large players are simply better equipped to navigate legal complexities; regulations and litigation alike, and despite beating each other up occasionally, will likely take share from smaller participants over time. Additionally, since nothing is set in stone, I refuse to bet on a single horse, so to speak.
Thanks excellent well researched piece on last member of big 3.
Don't know what you can do after BAT clears the bases perhaps a follow up on Swedish Match?
You've inspired me to reread Ashes To Ashes by Richard Kluger a history of the American Tobacco industry with a focus on the "secret six", fascinating but very dense 807 pages.
I do intend to write on Swedish Match, but intended to hold off until any material updates were provided regarding PMI's tender offer. I may visit some of the smaller participants and will undoubtedly revisit the 'big 3' as the future unfolds.
Wonderful write-up! A quick question on the valuation methodology used in your DDM with Exit Multiple. I noticed that you strip out adjusting items from terminal EV then discount to PV whereas, to my knowledge, common consensus is discount terminal EV THEN strip our adjusting items to get PV of Equity (otherwise you would be double discounting the debt and cash). Perhaps I'm just naive to this specific modeling technique as my DDMs typically gets capped by a perpetuity TV and, truthfully, I'm partial to FCFF models where I'm significantly more comfortable. I notice that were you to compare FMV using these two TV methods you end up with a near $20 intrinsic valuation differential due to the significance of debt on the valuation. It would be extremely helpful to understand your thought process in deriving PV of Equity!
James, thank you for the thoughtful comment and question! I'm right there with you: I feel more comfortable calculating unlevered FCFF DCF models and have included such in multiple pieces. Nonetheless, I try to chop it up and look at each company from various perspectives.
In an unlevered model, as you said, we discount EV back to PV and factor in cash, debt, investments, etc. to get an equity value. Such an approach does not explicitly assume how cashflows are distributed. In a levered version, we're granular with such things. The 10-y exit model assumes debt/cash/etc. is constant until the exit period and is a snippet of much larger and more grotesque calculations. In them, I'm approximating the firm's ability to convert EBITDA to FCFE. Not wise to do unless you have a relatively mature business with a relatively predictable footprint and D&A. Part of that conversion ratio is also a function of the (I) of the debt through time. There is also a margin of safety in the conversion ratio. In other levered approaches, you can model how rates/rolling debt/retiring debt can affect (I) and thus the EBITDA/FCFE conversion. Additionally, we're discounting the equity value by the CoE, which is markedly higher than the WACC we'd use to discount the EV. You can adjust for these differences in an unlevered DCF and produce similar results.
Is this pretty? Very much no. But I'm pretty vocal about modeling and prefer roughly painting ideas through numbers rather than attempting to gain a false sense of precision. Rates, multiple, FX, execution of operations, regulation, etc. can (and probably will) result in a future that looks a fair bit different than illustrated. The aim is to be directionally correct and conservative enough that it works in one's favor.
I hope this clarifies the approach. I'll consider switching it up in future posts to present additional angles. Thanks again for the great question.
Thank you for this detailed answer! This was extremely helpful in understanding the modeling decisions. As mentioned in my original post, these write-ups are amazing well put together. Truly a great resource in evaluating the tobacco industry as a whole.
Thank you so much James. I appreciate you reading and your excellent questions. Never hesitate to reach out!
Thanks for the detailed article. All is not well between BAT and ITC ( Indian associate). BAT is against to unrelated diversification whereas ITC is going ahead with it. BAT infact stopped ITC to issue new ESOPs so as to stop diluting its stake in ITC. So your assumption that BAT can influence policy in India through ITC is something to take a conservative view on unless BAT explicitly mentioned the same with solid backing.
Great point. Thanks for your input. I agree that the relationship (and India's market broadly) are more complex. My conservatism is expressed by fully discounting the equity investment in the valuation. While it may not be smooth sailing, the stake is most certainly worth more than 0 - and probably quite a bit more at that!
Just an update : ITC is investing in pure nicotine production facility. The facility is being geared to manufacture purest nicotine derivatives conforming to US and EU pharmacopoeia standards. Looks like they shall export the same. As per my limited understanding derived from reading ur detailed blog posts, I am guessing that these nicotine derivatives may be used in nicotine pouches / those reduced risk products which are the current most happening products in tobacco world. This may help ITC also when these kind of products are allowed in India. I believe ultimately Indian Govt shall allow these reduced risk products ( no idea when this shall happen though) as the entire world is moving towards reduced risk products. Phillip morris though the leader through products like IQOS is having limited presence in India through Godfrey Phillips in which they have 25% stake. But the promoters of Godfrey Phillips are not trust worthy and have questionable track record. BAT through its two associates like ITC and VST is on a better footing in India for sure.
A good deal of the industry is working behind the scenes to head down a similar path. PMI has Vectura Fertin. BAT has its own operations similar to Fertin. It will be very interesting to see how it unfolds. Thanks so much for your input, Sunil.
Pleasure is always mine. Thanks a lot for the detailed analysis once again.
Great piece, bud. I’m growing very fond of your thorough analysis and views on this “orphaned” sector.
Thanks for following along John. Plenty more ahead!
Thank you for this in-depth article!
How concerned are you by the Aug 17th patent infringement judgement against BAT: https://news.bloombergtax.com/ip-law/philip-morris-gets-14-million-from-reynolds-on-e-vapor-patents? The amount that BAT needs to pay PMI is minor, but PMI is also asking for either an injunction on the sale of Vuse Alto (BAT's best selling ENDS in the US) or royalty payments.
BTW, there's a minor typo in the first table, S&P's latest rating change was Feb 11, not Nov 2: https://disclosure.spglobal.com/ratings/en/regulatory/article/-/view/type/HTML/id/2794479. I assume you swapped the day and the month.
The CR date was fixed. M/D was indeed flipped. Wonderful catch, thank you.
Regarding disputes - I am nothing close to a patent law expert, so must defer to others. Alto PMTA is still under review, so not far-fetched to think BAT pushes MGO products to fill potential void while iterating future versions that skirt specific patents.
For the U.S. space specifically, I'm much more interested in following if/when the FDA will begin to enforce against smaller participants and if we will see meaningful changes in approach to synthetic nicotine. This would undoubtedly impact a huge % of the fragmented market; especially the growing disposable subsegment.
My broader thesis revolves around the fact that large players are simply better equipped to navigate legal complexities; regulations and litigation alike, and despite beating each other up occasionally, will likely take share from smaller participants over time. Additionally, since nothing is set in stone, I refuse to bet on a single horse, so to speak.
Thanks for reading and for your input!
***UPDATE See Below:
https://content.seleritycorp.com/hosted2/assets/www/lPW4gCvD3f-vaQv26JZKGokr3d5izsUpKjuZ3YsNq24
Thanks excellent well researched piece on last member of big 3.
Don't know what you can do after BAT clears the bases perhaps a follow up on Swedish Match?
You've inspired me to reread Ashes To Ashes by Richard Kluger a history of the American Tobacco industry with a focus on the "secret six", fascinating but very dense 807 pages.
Thank you!
I do intend to write on Swedish Match, but intended to hold off until any material updates were provided regarding PMI's tender offer. I may visit some of the smaller participants and will undoubtedly revisit the 'big 3' as the future unfolds.
my 1 company in the portfolio