Description

Description

Thesis:

I recommend the purchase of shares of British American Tobacco.  I think that it is a superb opportunity to invest in a high-quality business, with a 9.3% dividend yield and 14.9% free cash flow yield to the equity based on 2024 forecasts, with an asset worth 16% of EV contributing just 6% to earnings.  A director just bought USD $250K worth of stock last week. 

On a valuation basis, it is trading at multi-decade lows, below the valuation in both 1999-2000, 2008-2009 and March of 2020.  Adjusting for its stake in ITC, the company is trading at EV/EBIT = 6.1x based on 2024 forecasts.  Altria is trading at EV/EBIT = 7.7x (adjusted for its stake in Inbev), for a vastly inferior business, and much worse history of capital allocation. 

There are three potential catalysts, one is financial and two operational.  I expect the company to resume share buy-backs in the second half of 2024.  Operationally, I expect profitability to improve as non-combustibles turns profitable and reaches group margin levels.  The last catalyst will occur if the company receives FDA permission to bring its Scandinavian oral nicotine pouch products to the United States, which will most likely sharply improve the performance of its US business.   The company has been beating Swedish Match in Scandinavia with its nicotine pouch products, the opposite of what has been happening in the US. 

All Figures in the write-up are in British Pounds Sterling (L or GBP)

What has changed since the last write-up seven months ago?

Valuation and management. 

Since the last write-up on 01/19/2023, the stock is down 15.3% in USD, while the value of its stake in ITC went up by 31% or USD 4.6bn, and the EV/EBIT, adjusting for the stake in ITC went from 8.1 to 6.1. 

The old CEO, who many investors disliked, got fired by the board and replaced by the CFO. 

Description of the business

Given previous write-ups by MadDog2020, virtualodin and Gandalf just seven months ago, this section will be very brief. 

British American Tobacco is the world’s second largest tobacco company (excluding China National) operating everywhere in the world other than China.  The company sells both traditional cigarettes, as well as nicotine pouches, vaping and heat not burn products.   The company expects that its vaping and heat not burn business will turn profitable in 2024. 

In 2022, roughly 53% of its operating income came from the US, and 47% from the rest the world (not including India and China.)  The company has a subsidiary in India (ITC) of which it owns 29%, which is a conglomerate listed on the stock exchange.   The value of the company’s stake in ITC was = USD 19.4bn or GBP 15.45bn on 08/25/2023 or roughly 16% of the firm’s EV.

Operating performance

Historical

The firm has done very poorly in the US over the last couple of years, with double digit volume declines in its cigarette business, driven by market share losses, as well as shift of consumers from cigarettes to nicotine pouches.  It has also been hurt by the menthol ban in California.  The company’s presence in the sharply growing nicotine pouch business in the US (30-40%+ per annum) is virtually non-existent. 

H1 2023 results: 2.6% constant currency revenue growth, adjusted diluted EPS up 5.3% at constant FX to 181.6; adjusted EBIT up 2.7% on organic basis to 6.02bn, adjusted net debt = L 37.259bn pounds, volumes down 4.1%, driven by 4.9% decline in combustibles.  Cigarette volumes dropped 5.7% largely due to US down 12.4%, while the industry in the US was down 8.4%.  US was also hurt by California menthol ban.  Global duty paid industry cigarette volume was down 3%. 

2022 results: 2.3% constant currency adjusted revenue growth, 4.3% growth in constant currency in adjusted EBIT to L 12.408bn, 5.8% growth in constant currency in adjusted EPS to 371.4p, 0.5% increase in constant currency in net debt to L 38.131bn.  6.0% dividend growth to 230.9.  Company is exiting Russia and Belarus.  Company bought back L2bn worth of stock.  Volumes down 4.2% in 2022, with combustibles down 5.2%, while duty paid cigarette volumes globally for the industry fell 2%.  US cigarette volumes for the company were down 15.5% to 59bn sticks.  Market share in the US modern oral collapsed, falling from 11%+ to 5%, losing 580 basis points of market share and volume down 50.1%.  Filed to bring Scandinavian product to the US. 

2021 results: 6.9% constant currency revenue growth, 5.2% growth in constant currency in adjusted EBIT to L 11.15bn, 329.0 EPS up 6.6% in constant currency, adjusted net debt down 11.1% to L 35.548bn.  Company disposed of its operation in Iran.   Volume in the US was down 5% on a reported basis, and 7% on an underlying basis.  Volume for the entire business up 1.2%.  1.0% dividend increase to 217.0 pence.  7% adverse currency headwind in 2021.  Volume in 2021 benefited from October 2020 acquisition of Dryft in the US, which helped almost triple company’s nicotine pouch shipments in the US and get it to 11.7% market share. 

2020 results: 3.3% constant currency revenue growth, 4.8% growth in constant currency of adjusted eBIT to L11.365bn, adjusted diluted EPS up 5.5% in constant currency to 331.7 pence.  Adjusted net debt down 5.3% to L 39.451bn.  Volume down 4.3% with combustibles down 4.5%.  In the US, group cigarette volume up as 0.5% and other categories grew strongly.

2019 results: 6.2% constant currency revenue growth, 6.6% adjusted EBIT growth to L 11.13bn, 8.4% adjusted diluted EPS growth.  Adjusted net debt = L 41.726bn.  Volumes down 4.4% 677bn sticks, with cigarette volumes down 4.7% and THP volume up 31.6%.  In the US, volumes were down 6.0%.   Dividend per share up 3.6% to 210.4 pence, and adjusted diluted EPS = 323.8 pence. 

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Forecast going forward

2024

I expect the company to hit analysts’ forecasts of GBP 12.8bn in adjusted EBIT in 2024.  L 9.1bn in free cash flow to the equity in 2024.  Given 2.237bn s/o, FCF/share = 404 pence.

I expect the company to utilize L 5.37bn to pay dividends, L 2.63bn to pay debt, and L 1.1bn for buy-backs. 

Assuming shares bought back at 2600 pence per share, at 12/31/2024, net debt = L 33.37bn, s/o = 2.196bn. 

[Free cash flow in 2024 = L 12.8bn of EBIT - L 1.67bn of interest (5% * L 34.7bn average net debt) – L 2.78bn tax (25% tax rate) + L 750MM from ITC.  I assume 5% interest rate since it was 4.3% in H1 2023, and debt had average maturity = 9.9 years on 12/31/2022.]

2025

For 2025, analysts forecast GBP 13.4bn in adjusted EBIT, which results in L 9.6bn in free cash flow to the equity or 438 pence per share (assuming zero shares bought back.)

I expect the company to utilize L 2.5bn to pay debt, L 5.42bn to pay dividends (so 3% increase on a per share basis), and L 1.68bn for share buy-backs.  Assuming shares bought back at 2600 pence per share, at 12/31/2024, net debt = L 31.125bn, s/o = 2.132bn.

[Free cash flow = L 13.4bn in EBIT – L 1.69bn interest (5.25% * average debt = 32.12bn) – L 2.93bn tax + L 850MM from ITC = L 9.63bn. 

2026 and beyond

Free cash flow is unchanged in 2026 and increases at 1% per annum driven by growth at ITC.  All free cash flow is paid out as dividend, no shares are bought back, and no debt is paid down.  Interest rate on debt = 5.8%

Assumptions: 3% annual volume decline, pricing = inflation = 3%.

Free cash flow = L 9.63bn in 2026 or given 2.132bn s/o on 12/31/2025 = 451 pence per share or

17.4% dividend yield on 2589 pence price on 08/25/2023. 

Possible upside to numbers

1. Canada tobacco litigation gets resolved, and company can access cash and profits generated by its Canadian subsidiary.
2. Operating margins improve driven by sharply higher profitability and rising proportion of reduced risk products.
3. Company is able to get FDA permission to bring its Scandinavian nicotine pouch products to the US, increases its market share in the nicotine pouch business in the US, and thus is able to reduce US and global share losses and reduce volume declines to industry average of say 2% per annum. 

Capital Structure

s/o = 2.237bn on 06/30/2023.

Net debt = L 37.26bn on 06/30/2023.   Debt had 9.9-year average maturity on 12/31/2022.  Average cost of debt = 4.3% in H1 2023. 

ITC stake

As of August 25^th, 2023, the value of the group’s stake in ITC = L 15.45bn or 16% of EV. (The company should have received a L 330MM dividend in August of 2023.)

The company accounts for ITC’s stake under the equity accounting method.

In H1 2023, the group’s share of ITC earnings after-tax increased to L 319MM from L 262MM.

In 2022, group’s share of ITC earnings = L 514MM post tax up from L 419MM in 2021. 

Will it be monetized?

British American Tobacco has stated on a number of occasions, that the stake in ITC is strategic, and will NOT be monetized.  However, that does not mean that the shareholders of BATS will never see the benefit.  ITC pays most of its earnings out as dividends (3.49% trailing dividend yield), and since it is a conglomerate, it may periodically spin-off non-tobacco assets.  For instance, over the next twelve to eighteen months, ITC is spinning off its hotels business, which analysts expect to trade at 40x EBIT, and BATS is expected to sell its shares of the spun-off hotel business.  The proceeds to BATS should be around L 500MM or 3.3% of the value of the stake. 

Is the current market value reasonable?

While the valuation of ITC is quite high, analysts expect significant growth over the next five years.  The stock is trading at 26x this year EPS, however the multiple falls to 18x EPS four years out (year ending 03/31/2028.)  In my opinion, a reasonable price for a fast-moving consumer goods company in a market with tremendous potential – India. 

GQG Partners, a highly successful investment firm run by Rajiv Jain owns 1.44% of ITC and has been buying more according to latest filings on Bloomberg.  It also has large investments in both British American Tobacco and Philip Morris International.

 Valuation

Shares are trading at 6.5x 2024 consensus EPS estimates, 6x 2025 consensus EPS estimates and 5.2x 2026 consensus EPS estimates.

On 2024 numbers, adjusting for its stake in ITC, the company is trading at 6.1x EV/EBIT (based on 2024 forecasts) using debt at balance sheet value, and even lower marking debt to market. 

Capital Allocation

Aside from buying RJR business in 2017, the company just pays dividends and occasionally buys back stock.  Its stock repurchases in 2022 in retrospect we clearly poorly timed since the stock is lower now.

It is not Altria, but neither is it Philip Morris International with its superb purchase of Swedish Match. 

Expected Returns

I expect 15%+ annual nominal returns (in the world of 3% inflation) assuming no re-rating of the stock, purely from dividend alone.  The upside might be higher if somehow the stake in ITC can be monetized against the company’s wishes. 

Risks

1. Menthol gets banned everywhere in the US leading to share losses and volume declines for the company.
2. The company is not successful in defending its market share from the entrance of Philip Morris International into the US with its heat not burn products.
3. Sharp increase in federal excise tax in the US.
4. More jurisdictions globally attacking the cigarette/tobacco industry via lawsuits like what happened in the US and Canada.

Conclusion

A unique opportunity to invest in a high quality FMCG business at the lowest valuation in at least thirty years, with almost a double-digit dividend yield, and 15%+ expected forward returns.

Catalyst

Share buy-back and operational improvements. 

Catalyst

Share buy-back and operational improvements.