Description

Summary

British American Tobacco (BTI) has been a value trap for the past five years, trading in a tight $32-45 band since late 2018.  At 7.8x forward earnings, BTI now trades at a valuation lower than during the worst of the Great Recession, and roughly in line with its lows in March 2020.  With an 8.3% dividend yield, BTI is perhaps the cheapest quality value stock we have seen in a long time.

Apart from the valuation/yield, we like the fact that it generally is non-cyclical, will benefit from a weakening dollar and is on the cusp of improvement in earnings growth.  Inflation has had little impact on the company either.

BTI long term expects earnings growth in the mid-single digits.  With buybacks, EPS likely grows by 6-7% per year, inline with the past decade’s growth (6.7%).  Throw in the 8%+ yield, and without any re-rating whatsoever and BTI can be a 14-15% IRR stock for investors. 

However, we think that there is a good chance that BTI is nearing an inflection point in terms of growth.  In 2024/2025, growth may accelerate to perhaps the high single digits or low double digits.  As the company adds non-combustibles to their mix, margins should continue to move higher as the company scales into these products.  Non-combustibles are also taxed at lower rates than cigarettes.  As we have seen with Philip Morris International (PM), the market is more willing to pay a premium multiple for a tobacco business with a larger percentage of non-smoking products in the portfolio.

We peg the downside in BTI at $33-35 (from $36 today), and upside to $50-70 plus dividends in 1-3 years.

This is a chart of the forward P/E ratio for BTI back to 2005.  It trades in London under the BATS LN ticker, and in the US as BTI.

Business

Tobacco is a bit of a misunderstood industry.  Heavy regulation and limited ability to advertise ensures that new entrants have almost zero shot at entering the space.  Big tobacco will only get bigger.  Disruption appears less and less likely too as the winners in the e-cigarette space have already been written.  Juul market share is today well below BTI’s Vuse.  

Bears point out that tobacco names will never trade at historical P/E multiples owing to heavy government regulation and the movement toward ESG investing.  But the irony is that regulation only ensures that the supply side of the industry remains tight.  Moats are gigantic, and EBITDA margins tend to run well over 50%.  Cessation rates have been stable for years (decades in fact), and with pricing power, the tobacco industry typically offsets volume declines (in the 1-6% range depending on the country), with price increases. We estimate that BTI earns over 70% gross margins on its e-cigarette products vs 50% for cigarettes. 

While investors today seem loathe to pay a decent multiple for a volume declining consumer staple, the reality is that 1) prices are quite low in the US still (compared to other geographies) and 2) volume increases in smokeless products will eventually tilt the overall balance into lower volume decline.

On the ESG front, research indicates already that vaping and heat not burn products are dramatically safer for users than combustibles.  BTI is also a member of the Dow Jones Sustainability Index.  Some ESG backlash could also improve the odds of institutional acceptance of tobacco names. 

Capitalization

BTI levered up to purchase Reynolds in July 2017.  At closing, BTI was approximately 4x levered on a debt/EBITDA basis.  For a company worth between 7-12x, it was on the high side.  Today leverage is quite manageable at 3.2x, and the company expects that to fall to 3.0x by year end 2022 when they report. Long term their goal is 2-3x leverage, but even at 3.2x currently, the company is investment grade rated BBB+/BBB2.

The dividend is probably the number one priority for most holders of BTI.  They have grown the dividend at a 7% CAGR over the past decade, and target a 65% payout ratio of net income (where it is today).  FCF conversion tends to hover very close to 90-100%, so the risk of a cut seems quite low. 

Business

There is a prior VIC write up of BTI worth reading for some background.  The company IPO'd in 1998 after BAT Industries separated their tobacco unit, British American Tobacco.

While BTI has made many smaller acquisitions over the years, the largest was its purchase of the 57.8% stake in Reynolds American in mid-2017 for $27BB.  They paid 9.5x on an EV/EBITDA basis, which seems about 1 turn expensive given today’s multiples.

Here is their current portfolio divided by management into “Combustibles” like cigarettes, and “Non-Combustibles” which includes “New Categories” like e-cigs.

Below is a listing of BTI’s brands:

The company’s goal is to gradually migrate away from the traditional combustible cigarettes to vaping devices (Vuse), tobacco heat products (glo), and nicotine releasing modern orals (VELO).  VELO is a nicotine release pouch placed in your mouth but requires no spitting.  

By region, here is a breakdown of Adjusted Operating Profits.

The US weighs in at 53% of profits on a runrate basis. 

There is also a line above illustrating tobacco volumes, which we adjusted in 2017 to account for the Reynolds acquisition.  Through 2021, the five-year organic decline in cigarette volumes sits at a very manageable 1.3% per year. 

In 2022, BTI management expects global tobacco volumes to decline by 2%.  In each of the past three years, BTI has expanded its market share in combustibles by about 20 bps per year.  In the US smoking demand is correlated somewhat to gas prices (that is high gas prices will lead to more volume declines).  As gas prices continue to moderate, US volumes may also improve.

New Categories

Growth will come from the company’s New Category products: VELO, glo and Vuse.  Management’s goal is to get to £5BB in combined sales by 2025 in New Categories.  They believe annually they can grow in the 30-40% range, which appears more than doable given 1H 2022 results (with revenue up 45%).  In 2020, growth was muted as many retail stores were closed.

Overall Non-Combustibles today represent 10% of total revenue (1H 2022).  Market share gains have been impressive, and growth appears to be re-accelerating after a lull from the Juul flavored pod media scrutiny, and Covid-19. 

BTI has suggested that they will be about breakeven on its New Category revenue in 2023, with losses today around 440mm (annualized). 

Vuse is their fast growing vapor product, with 40% market share compared to 28% for Juul.

Industry

The legal global tobacco industry as of 2019 was $818BB (USD).  Vapor sales were worth $20.2BB that year and THP (tobacco heated products) another $15BB.  That is 4%. 

Remarkably, governments collected $200BB in taxes on that $818BB figure, or ~25% of revenue. 

19% of the world’s population still smokes, but as an addictive unhealthy product, there are roughly 2-3% volume declines annually.  Most if not all of this tends to be offset by price increases.  With price increases, cost cuts, scale and smoke free product growth, the big three tobacco names have been able to grow EPS by about 7% per year. 

In the US, cigarette volumes tend to decline by ~4-6% annually, with the rest of the world down 1-3%.

A lot of bad news has impacted tobacco stocks over the past few years.  Juul was growing in popularity among underaged kids.  After a few deaths (mostly linked to using illegal and tainted marijuana pods in Juuls) the media wrote prolifically on the subject and created quite a stir.  Flavored Juul pods were largely to blame for encouraging underage vaping.

In response to this, in 2019, the legal minimum age to purchase tobacco was raised to 21 in the US.  The FDA also banned all flavored pods except for menthol.  Tobacco equities took a nose dive in this period and have simply never recovered (except for PM to some extent). 

The concern at BTI is that a menthol ban in California could spread to the entire US.  That could have an outsized hit to them.  However, we note that similar menthol bans in other countries have not impacted cessation rates materially.  From December 8th,

Tadeu Marroco, Finance and Transformation Director "Well, look, the California flavour ban will be, if anything, an interesting experience, I would say, because there is always this question about the menthol ban coming through in the US, what happens and with the level of exposure BAT has in the US. We always try to quote back and make analogies of what has happened in other markets in terms of Canada, in terms of Turkey I think more recently, but also Europe, and what we have seen in all those markets is that consumers, they smoke first, and they are very loyal to their brands, and not necessarily for a menthol or non-menthol. So, the level of retention in those markets that have implemented a menthol ban is still very high, and that’s why we were not always in agreement towards this view of levels of exposure's too high and so on and so forth."

In the US, Altria has 52% market share among its tobacco brands.  BTI has 35% share and ITG 7%.  PM operates outside of the US.

As for the impact to growth in non-combustibles, market shifts to Vuse and glo/VELO could lead to higher margins.  While difficult to quantify, below is one simple scenario, taking 2022 estimates for BTI, and assuming that over 5-10 years that 1/3 of cigarette users switch to a non-combustible product. 

Above, we assumed 1/3 of their sales faced 8% excise taxes and the rest at 26.5%.  Just that transition alone might improve margins by 6% points and net income by 16%.

We believe that governments will tax cigarettes far higher than non-combustibles given that they are far less detrimental to one’s health. 

Projections

We didn’t assume anything at all heroic in our estimates, and generally stuck to Street numbers.  In 2022 in the first half, EPS grew 5.7% at constant FX rates. 

Here is our summary model, with figures reported in British pounds, and an EPS line also in US dollars.

Lots of analysts cover BTI, and the company seems to manage expectations quite well.  Adjusted EPS has outperformed guidance in every year dating back to 2014 (but not by much, usually 1-3%, as this is a mature and stable business). 

Management has historically targeted 5% revenue growth but that will be 2-4% in 2022, with 2022 EPS growing mid-single digits (implying some deceleration in the back half of 2022). 

Management embarked on a 1.0BB cost savings initiative in 2019, mostly to fund building their New Categories brands.  These cost savings now are expected to reach 1.5BB by 2022. 

Since 2014, EPS has grown 6.8% annually (through 2021).  With an average yield of just under 5%, that works out to 12% annual returns for shareholders.  The stock today yields 7.7% and we target roughly 7-8% EPS growth in 2024 to 2025, but there is a chance it is better given their New Category growth.

Valuation

Given the ESG aware investing environment, we are not assuming BTI can trade back to its average historical multiples, which is 12x EBITDA and 13x earnings (P/E).

But 10-11x earnings seem quite doable for a company growing EPS by 7-8% and revenue in the mid single digits. 

Philip Morris (PM) offers the best growth metrics, with EPS expected to expand by 10-12% ex-currency impacts in 2022.  With 28.6% of revenue at PM from smoke free products, and no exposure to the US markets, it appears the best quality name in the industry.  Their purchase of Swedish Match and the company’s goals put their revenue in smokeless products at 50% by 2025 (vs 20% at BTI).

PMI trades at 13.6x 2023 EBITDA, and 17.3x 2023 earnings. 

Altria (MO) trades at 8.3x 2023 EBITDA, and 8.9x 2023 earnings.  It is expected to grow revenue by 1-4%, with EPS growth in the 3-5% ballpark. 

As far as British Tobacco goes, we think fair value is between MO and PM, but probably closer to MO given their lack of smokeless products. Still, their higher growth suggests a better than MO multiple.

We posit a 9-11x multiple is conservative and fair value for BTI.

At 10x 2024, BTI would be worth $57.76, upside of 52%. 

Our very long term forecast suggests that at just 6% EPS growth, plus dividends (assumed to be flat actually), and BTI would be a 12% IRR investment, which we deem highly likely to be at least as good as the S&P in a decade.

Conclusion

BTI is a solid long term compounder, with growth perhaps on the verge of inflecting higher. 

In USD terms, EPS grew at a CAGR of 8.8% from 2005 to 2021, and a 6.8% CAGR from 2014 to 2021.

From 1999 to today, BTI has earned investors a total return of 15.0% per year, vs the S&P up 7.3% over the same timeframe.  And that is despite the stock trading at record low valuations today.

Our downside case is in the $30-33 range near term, but we expect upside of 20% to over 80% in one to three years.  

Catalyst

Noise surrounding menthol ban ends, easier comps in USD terms in 2H 2023, easier comps in 2H 2023 as Russia/Ukraine impact dissipates