Description

The global tobacco businesses are trading at 10 year lows (EV/EBITDA multiples below, British American Tobacco (BAT) is red and global tobacco is purple), implying that they’re dying businesses, but a look under the hood of BAT suggests this is not the case. 

BAT is taking incremental share in the higher margin, Non-Combustibles business and is using cost savings from the core business to fund their investments in Non-Combustibles.  BAT’s US business (~half of profits) is under monetized, especially after Juul’s significantly weakened position, and the pricing power of this business should drive continued FCF as the Non-Combustibles business grows.  

Business overview

BAT is the largest global tobacco company, with ~75% of revenues from developed markets and ~25% from emerging markets.  It derives roughly half of its profits from the US business, which it now fully owns after acquiring the remaining 48% of Reynolds American (think Newport, Camel, Natural American Spirit and Lucky Strike) in 2017.  

The business is primarily (~90% by revenue) a traditional cigarettes and cigars business (combustibles) but BAT is continuing to make progress on alternative products.  Unlike its combustibles peers, it is more diversified in non-combustibles as it currently has top products in all the alternative categories.   

As we know from watching Juul’s rise and fall, the key concern in the tobacco business has been alternative delivery methods of nicotine.  There are three primary new areas of competition (New Categories) for cigarettes.  The first is heat not burn products (Tobacco Heated Products), where Philip Morris is the global leader with its IQOS product and BAT is #2 with its glo product.  The second is vaping or e-cigarettes, which is the category that Juul was building.  BAT’s primary product here is Vuse and after Juul’s regulatory issues, Juul is and will likely be ceding market share going forward.  BAT is now the largest vaping player in its top five markets, including the US, in terms of devices sold which is a leading indicator for ultimate market share.  The most recent #s by device sales suggest BAT is likely to end up with a minimum of a strong #2 position across these markets, and potential lead the vaping market.  The last new category is Modern Oral, which is a tobaccoless pouch that contains nicotine and importantly does not require spitting.  BAT is consolidating its position around the Velo product.  Velo is a leader outside of the US and ~9% of volume in the US, after just launching Velo in the US a year ago.  This category is still nascent but early signs are positive.  

Historical global nicotine revenues split into Combustibles (blue) and Non-Combustibles (yellow) are shown below.

Given the importance of the US market, the current US shares by category are below.

Three key priorities

BAT arguably needed a clear and simple focus to allow the company to execute and that’s what Jack Bowles, the new CEO as of April ’19, has provided.  He laid out the following three priorities for BAT and has been executing against these since.

1. Combustible value growth (read driving pricing) – the US is the clear driver here and for context, the word pricing was used 26 times in the H1 call last month.  More details in the Combustibles section below.

2. Simplify the company – BAT had too many layers of waste and they are eliminating this through Project Quantum.  The phase 1 goal was to eliminate £300m of costs, which they have largely completed.  The beauty of this is that they are using these cost savings to fund their investments in New Categories.  For example, they saved £240m this year and used that to invest £250m in New Categories marketing.  Phase 2 has a target of £700m in savings and they are getting ready to launch this effort with a target of 2022 completion.

3. Step-change in New Categories – This will primarily be driven by the three New Categories (THP, Vaping, and Modern Oral) but also includes Traditional Oral.  There are 68m consumers of Non-Combustibles globally today, which generate ~£16B of revenue.  Currently, BAT generates ~10% of revenue from Non-combustibles, comprised of 11.6m customers and ~half of the Non-Combustible revenue coming from these New Categories.  BAT generated £628m on New Category revenue in H1 2020 (~£1.2B annualized) and their stated target is £5B of New Category revenue by 2025.  Longer term, their target is 50m Non-combustible product consumers in 2030.

Combustibles (traditional cigarettes)

Traditional tobacco volumes had been declining at ~4% per year, which was more than offset by price increases.  The last few years have seen 7-8% volume declines, largely driven by Juul.  Given their weakened position, this headwind should abate.  2020 is a tough year to gauge, given COVID, but the US is tracking towards -2.5% in volumes.  Globally, tobacco volumes are likely to be down 7%, driven by both EM and duty-free sales in airports.  EM is the driver of this, with the most extreme example being South Africa.  Until last week, cigarette (and alcohol) sales in South Africa where banned since March (except for a brief lift during June).  For context, BAT generates £25m profit/month in South Africa.  During this time, the illicit cigarette trade went to 100% of the market and those prices increased by 300%.  As a result of this pricing umbrella, the post lockdown period for BAT should provide a great opportunity to reclaim that £25m profit/month opportunity.

Globally, BAT has been taking share on the margin and improving their overall mix, which has led to better than industry revenue growth (2.8% pa over the past three years vs. industry of 1.1%pa).  

The US makes up ~half of profits and is a key driver of profitability.  In December 2018, Altria panicked and purchased a 35% stake in Juul for $12.8b, valuing Juul at $37b.  Since then, it has written off $8.6b of their purchase and has replaced the Chairman/CEO.  The Juul debacle and the weakening of Juul’s position in vaping combined with Altria’s management changes should incentivize Altria to maintain price discipline.

So, what does that mean?  A pack of cigarettes in the US cost ~$8, meaningfully below the world leaders in cigarette prices: Australia at ~$18, northern Europe ~$14, and Canada at $11+.  To state the obvious, the US has the largest GDP/capita in the world and therefore these businesses should have ample pricing power looking forward.  BAT reports price elasticity for the US industrywide at -.38, also suggesting continued pricing power going forward.  

New Categories (THP, Vaping, Modern Oral)

There are 1.1B combustibles consumers outside of China and India.  On the Non-Combustibles side, there are 68mn consumers with BAT currently having 11m of these.  This is the big opportunity for them to drive growth over the next five years and is a major priority.  New Categories not only generate higher levels of revenue but are also higher margin than traditional Combustibles.  For context, New Categories generated £1.2B of revenue in 2019 and grew over 30% (details on the next page).  Traditional Oral (spitting tobacco) generated £1B of revenue and grew 10% at constant currencies (15% actual).  BAT’s stated goal for New Categories is £5B of revenue by 2025.  The combination of New Categories + Traditional Oral is now 9% of the overall business by revenues and is growing over 20%pa.  

BAT has the broadest Non-Combustibles portfolio and is an emerging leader in many of these markets.  

On vaping specifically, Juul is quickly losing share to BAT.  This was the preeminent threat several years ago, but recent signs continue to suggest this will be a strong category for BAT in the future.  Charts below show BAT’s position in Vaping by device sales as well as overall and you will see this improvement in positioning across these. 

All three of the New Categories are growing quickly but Modern Oral is growing the fastest, albeit off the smallest base.  As you will see below, Modern Oral is the smallest of the three New Categories but almost quadrupled last year and was just introduced in the US a year ago.  They have had a couple of COVID related hiccups on the rollout this year but their market share in the Europe, 50%+ in Scandinavia and 30% in Russia, combined with higher gross margins than cigarettes indicates the strength of this category.  BAT is in the process of consolidating their Modern Oral portfolio of brands around the Velo brand, which has been partially delayed by COVID, but should be completed by the end of 2021.

BAT is the leader in these pouches in Europe/North Africa, with 62% market share.  Their US share is 11%, after just entering the market in July of 2019.  There’s work to do here in terms of ensuring they have adequate US products, mainly above the 6mg nicotine level, but globally the Modern Oral market will be a key driver of both revenue and profit growth for them.  As you can see from their Capital Markets Day slide (below), they are in the early stages for Modern Oral but the signs are very promising.

ESG

Presumably nobody cares about a tobacco business focused on ESG but they have done an excellent job in this area.  They have received numerous accolades for this work, but the best example is that they are targeting carbon neutral by 2030.  They are the sole tobacco company in the DJ Sustainability Index and continue to lead across all three facets of ESG.

FX

A quick temperature check on FX suggests BAT is well balanced for a range of future currency outcomes.  Will the dollar maintain its current position of strength?  I have no idea.  But what I do know is the dollar is still expensive, see below, so the ~ 50% of profits in the US and 50% outside seems like a Solomonic solution.  The Euro and Pound are in the normalish valuation ranges and several EM currencies (25% of BAT’s sales) are downright cheap.

Balance Sheet

BAT leveraged up to purchase Reynolds, with a peak of 5.8x net debt/EBITDA on 12/31/17.  They have been deleveraging since and are at 3.7x today.  They are deleveraging at ~.4x a year and reiterated that they should be at 3x by the end of 2021.  

The debt is termed out, with staggered maturities over a decade+, with £2.9B due in 2021.  In this context, the lower P/E seems reasonable given the current debt levels, but the lower EV multiples insinuate these equity valuations are not driven by balance sheet concerns.

Expected Returns

What do you have to believe?  The dividend is now 8% so the key question is whether BAT can use its pricing power, primarily from the US, to offset volume declines in the traditional tobacco business.  Given the new management team and the cheapness of US cigarettes vs other developed countries, I believe this is highly likely to occur.  In conjunction with the current valuation, the current dividend yield is my reasonable, lower case scenario.  They have stated a 65% payout ratio this year so the dividend could decline for 2021 but they have adequate liquidity to meet this.  

The next key question is whether BAT can hit their stated guidance to deliver growth.  Medium term, their stated guidance is 3-5% constant currency revenue growth and high single digits EPS growth.  With the investments in the New Categories, the cost savings from Project Quantum, and BAT’s leadership positions across all three New Categories, I think there is a reasonable chance they achieve this.  The combination of this outcome and the dividend yield would get you to mid-teens IRRs.

The multiple is tricky.  Multiples are cheap over the last 10 years but maybe these are less desirable assets socially and therefore more likely to remain at these levels.  Any return towards modern history would get you to 20s+ IRRs but I do not have a strong view on the likelihood of this happening, so it is more in the nice to have bucket.  

Risks

Best guess of how this is wrong is if globally we experience high single digit structural cigarette volume declines.  Without a corresponding increase in New Categories volumes, this would be difficult for the business and would meaningfully reduce dividends.  Because of the pricing power of the US, I view this as unlikely but it is my biggest concern.

Catalyst

• Coupon clipping

• Continued price hikes in the US tobacco market

• New Category execution

• Deleveraging

• Improvement in EM broadly and South Africa specifically