British American Tobacco: Identity Crisis
“Forever. Forever? Forever ever. Forever ever?” - Outkast
£25,000,000,000. Twenty-five billion British pounds sterling. This is the amount that British American Tobacco will write down the value at which it holds several of its United States brands—now to carry with an estimated useful life of 30 years rather than indefinite. It would appear that the company has twisted the clock, set the stopwatch, flipped the hourglass, or whatever; the U.S. business is going to zero, and there is nothing to do but to watch the stock price follow suit. The company is in crisis.
If I had to guess, ~95% of the coverage provided to British American Tobacco since the release of its 2023 Second Half Pre-Close Trading Update can likely be distilled into the above, conforming to and perpetuating the long-prevailing narrative that the entire tobacco industry, not just British American Tobacco, is doomed. Such approaches to coverage are efficient at attracting eyeballs and garnering clicks; the priority of today’s media outlets. As for accuracy and appropriately capturing the state of the entire company as a going concern, they also happen to be insufficient.
There is no denying that British American Tobacco is facing considerable challenges. In the United States, the company’s largest segment by operating profits, volume declines have accelerated, illicit disposable vapes continue to proliferate, and new regulations are on the horizon. All considered, while the exact timing of the impairment charge was a surprise, the charge itself, fundamentally, was not—more are bound to occur for the industry. I point to the question posed by hip hop lyricist/vocalist/philosopher duo Big Boi and André 3000, also known as Outkast, in their 2000 hit Ms. Jackson, quoted in the opening of this piece: Forever ever?
Forever is a very long time.
Beyond the threats weighing on U.S. operations, the company’s massive strategic shift, in which it is prioritizing the growth of next-gen nicotine products, is set to further cannibalize legacy volumes, including the ones of brands attained through its 2017 acquisition of Reynolds, for which, it is clear, with the aid of hindsight, that the company paid too much for. However, it is hard to argue that such overpayment, with the overarching backdrop of an industry undergoing significant evolution, had not already been baked into the company’s prospects. Should a company touting the ambition of transitioning smokers to less-risky alternatives not be believed? It could be argued that this is merely a coping retort to distract from the fact that the core business, cigarettes, responsible for the vast majority of current profits, is set to precipitously decline into irrelevancy. But this would also miss the mark, as a useful life of 30 years is still an outrageous amount of time to continue spitting out cash. More importantly, this is not representative of the company as a whole. But what is the company as a whole and why would one be invested in it? That is a seemingly more difficult question for most to answer, and clearly more difficult compared to even BAT’s industry counterparts. Philip Morris International is the pack leader in next-gen products, by far. Altria holds a dominant share of premium legacy tobacco market shares in the most profitable country, the United States, and has no year-by-year headaches of awkward currency adjustments. Imperial Brands, considerably smaller and more nimble, has remained guarded in next-gen reinvestments as it continues to prioritize its legacy business while returning capital to shareholders at a voracious pace. Scandinavian Tobacco Group, far smaller still, often ignored, holds a dominant share of a niche; handmade cigars, and is also more aggressively returning capital. Relative to all of these, in which it does not appear to shine brightest in any one respect, British American Tobacco is facing a crisis of sorts. An identity crisis.
Much like a man facing a mid-life crisis, in which he changes his entire aesthetic to pair with a brand-new motorcycle, British American Tobacco wants to be seen as cool and hip, deploying considerable sums into new product categories, seen as a way to revamp its image. But unlike the man, who may ditch the motorcycle after nine months, British American Tobacco remains steadfastly committed to its new initiatives. In both cases, they are likely to realize that many of their best years are ahead of them, not behind.
Curiously eclipsed in reporting by the sizable write-down of U.S. intangibles, British American Tobacco’s Full Year Trading Update contained considerable additional information of key importance. The company lost the contribution of Russia following the sale of associated assets. The change in valuation, from my perspective, is positive, as my previous models had proactively removed related year-to-date contributions yet had not included any proceeds from the sale. BAT’s management has stated they have begun to receive payments related to the sale and will receive additional proceeds throughout the remainder of the year, though exact figures have not yet been provided. Despite the loss of Russia, operations throughout the rest of the world appear markedly different from the United States. Strong growth has been sustained in both AME and APMEA segments, following the growth in organic topline and adjusted operating profits of each in H1’23 of +9.1%/+7.8% and +9.8%/+9.3%, respectively. Supporting such growth in these segments is not just the strength of combustibles, but the continued rapid growth of new categories. These new categories are the source of most contention. They are viewed as untested, long-term prospects less certain, and perpetually unprofitable. This view does not fully reflect reality.
Contribution margins across the company’s new categories are set to reach parity with legacy products and even eclipse them. But this does not happen overnight, and achieving it does not come free. There are stark fundamental differences between new categories and legacy, in which, rather than trivial reinvestment and pricing to support cash flows on the back of significant brand recognition, new categories carry all kinds of costs related to R&D, new production, new regulatory navigations, IP battles, other legal proceedings, heightened marketing through limited channels, and questions surround the ability to build similar brand affinity and preference. Undoubtedly, pointing to these differences, the very idea that the company would focus on new categories and scale them was first thought foolish; the target of breaking even in 2025 was absurd. Yet earlier this year it was clear that the company was ahead of schedule, set to reach breakeven a year early, and would reinvest at an elevated rate. The company has now announced that 2024 will be a second year of heightened reinvestment, further weighing on near-term profits. The widely-shared response to this has been dismay, understanding that additional capital returns, namely share repurchases, will be delayed further. However, this fails to appreciate that once again, higher reinvestment supports a higher trajectory. The company now expects aggregate new categories to be breakeven not one, but two years ahead of schedule. Imagine the criticisms to be had if the company caved in to demands earlier in the year to aggressively retire share capital rather than feeding new categories and responsibly prioritizing its debt.
British American Tobacco continues to make headway toward its goal of reaching the midpoint of 2-3x net adj. net debt/adj. EBITDA, aiming for 2.7x by the end of the year. Despite continued repayment of debt, higher rates will continue to push financing costs higher as the company rolls maturities forward over the coming years. But with respectable coverage ratios, the overall concern is less front of mind—especially true if rates have marked the beginning of a reversal. Further aiding deleveraging, on August 14th, ITC shareholders approved the spinoff of its hotel segment, set to occur late next year. BAT’s management has stated having zero interest in being in the hotel business, and as the standalone entity will not be encumbered by Indian FDI regulations that weigh on tobacco, it is likely that BAT will move to monetize its related stake, as noted previously.
I have long argued that relative to peers, British American Tobacco faces the widest spectrum of potential future outcomes. There is no need to assume any positive catalysts, such as the FDA meaningfully cracking down on the illicit vaping market or added delay of the eventual federal ban on menthol cigarettes. Even with pressures mounting, the company’s aggregate global portfolio remains resilient. Full-year guidance has been reaffirmed, albeit at the lower end. Group organic net revenues are positioned to grow at a low single-digit level and the company is poised to convert operating cash flows at nearly 100%. Long-term expectations, broadly, are dismal. That is not a high bar for the company to clear. A revised valuation model will be published following the release of the company’s full-year statement. For now, I reiterate my remarks following H1:
Some have theorized that continued success in New Categories will lead to a positive re-rating. I remain unconvinced. This is an unloved company in an unloved industry with its primary listing in an unpopular market. Pessimism may continue to mount—especially on the back of looming regulatory actions. If share repurchases resume, growing negative sentiment may be ideal for long-term shareholders who are best served by focusing on continued execution. Even when subtracting out Russia and Belarus, growing reinvestment into new categories, and increasing interest expense, forward returns are supported by a hefty double-digit free cash flow yield. Trading at under x7 EV/EBITDA, with a conceivable path of low to mid-single-digit growth, this company does not need to do anything extreme for the equity to produce outsized returns.
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Ownership Disclaimer
I own positions in British American Tobacco and other tobacco companies such as Altria, Philip Morris International, Imperial Brands, and Scandinavian Tobacco Group.
Disclaimer
This publication’s content is for entertainment and educational purposes only. I am not a licensed investment professional. Nothing produced under the Invariant brand should be thought of as investment advice. Do your own research. All content is subject to interpretation.
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Good Article as always.
Living in Germany i have another view on BAT and the industry. I know that cigarettes are down a lot in the last year in the United States.
Here in Germany Vuse is going strong. It's often the only vape brand in supermarkets. They are in the gas stations etc.. Velo is doing strong and seems to be a market leader in the pouch sector ( outsite the US).
The valuation of the stock discounts all the positive outcomes like growth in alternatives, much highter smoking rates in other parts and the world and the growing markets in Asia.
Smoking is down in the US, yes. But i think the worldwide picture differs a lot. Yes , the US is the most profitable market, but i think at these valuations it s difficult to loose with a global tobacco stock.
Greetings Ulrich
First, many thanks Devin for your coverage of the Tobacco industry! You're by far the best analyst in the space and I'm very happy you offer your insights for free to the public.
As to the write-down, I do not take it lightly. Because it means that BAT in 2017 overpaid by 25 Billion, a sum that is now written down to zero. That is roughly double the sum that Altria deployed in its JUUL acquisition fiasco. Altria's capital allocation skills regarding the JUUL deal are presented now as catastrophic, and if one concurs with this judgement (though I know you don't), the Reynold's acquisition, for the fact that BAT by its own admission overpaid by 25 Bio, should be seen as more catastrophic still. And while the write-down is non-cash, the original deal in 2017 was both in cash and equity and its ripple effects will be felt for many years to come. First, by diulting shareholders with the issued equity; second, by loading the company with debt, which impairs the company's investment agility and its ability to return capital to shareholders (buybacks, more substantial dividend increases).
So in my view, it's more than justified that the stock price took a beating. There is a fundamental reasoning behind this and it cannot just be attributed to sentiment.
I wholly agree with your assessment that management has its priorities right with focusing on investment and deleveraging instead of buybacks. As far as I'm concerned, they could go much farther down the deleveraging road, as a continued suspension of buybacks would hopefully keep the stock price at depressed levels and thus provide for good buying opportunities.