August 28, 2020 - 4:41pm EST by
2020 2021
Price: 34.00 EPS 0 0
Shares Out. (in M): 2,286 P/E 0 0
Market Cap (in $M): 77,000 P/FCF 0 0
Net Debt (in $M): 60,000 EBIT 0 0
TEV ($): 137,000 TEV/EBIT 0 0

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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.