Description

Opportunity

British American Tobacco (BATS in UK, BTI in US) has been presented before on VIC, more recently by gandalf and virtualodin who eloquently described the business, including its history and business dynamics. BATS 2023 stock price weakness, counterbalanced by ITC continuous business and market cap growth, creates today an even more attractive opportunity.

BATS Businesses

BATS main business units include: US combustibles, International combustibles, Global Nicotine Non Combustibles and ITC, the Indian conglomerate.

BATS is currently trading at GBP 22.995, with P /2023 E of 6.3X, EV / EBITDA of 6.5X, FCF yield of 16% and dividend yield of 10.1%. The reason for the extremely low valuation is a combination of fears related to the structural and accelerating decline of the US combustible business, combined with the low appeal of investing into a non ESG friendly industry and a UK listing. 

US Combustibles – 36% of Revenues in H1 2023

The fears related to the US combustibles business are realistic, as in H1 2023 we had a severe acceleration of volume -12.4% and revenue decline -7.4%. These results, together with the $31.5Bn impairment of its US brands intangibles, have created the severe trade down in the company stock. 

International Combustibles – 46% of Revenues in H1 2023

The international combustibles segment is still strong as it grew 7.6% in H1 2023

Global Nicotine New Products and Other – 18% of Revenues in H1 2023

New Products also grew mid double digit at 15.8% and Other grew at 9.6%

Summarizing, all of BATS businesses excluding US combustibles contributed to 64% of revenues and grew at a rate of 9.4% in H1 2023.

ITC Stake

As part of the other business segment, BATS owns 29.19% of a GBP 54.2 BN Market Cap Company for a stake value of GBP 15.9Bn. This is a very strong business including cigarettes, consumer products, agricultural and hotels. The business has had an outstanding record of growth with double digit EPS CAGR over the last 10 years and a P/E in the high twenties.

BATS ex ITC Key Stats and Analysis

To estimate the standalone value of BATS ex ITC stake, I subtracted the value from BATS Market Cap and adjusted its EBITDA, Net Income and FCF. The adjusted KPI show a BATS P/E of 4.7X, EV / EBITDA of 5.7X and FCF yield of 22% with 2023 Net Debt / EBITDA of 2.86X, just slightly higher than the unadjusted 2.7X.

Investment Return

Base Case – 20% IRR (10-11% Div Yield + 9.5% MKT Cap CAGR)

I simulated an investment return analysis using a base case scenario reflecting management recently revised EPS growth guidance of 4%, 2%, 3%, 4% in 2023, 2024, 2025 and 2026 respectively and a fixed 6.5X EV / EBITDA multiple. I assumed dividend and EBITDA growth in line with EPS growth. 

Worse Case – 8% IRR (10% Div Yield - 2% MKT Cap CAGR)

 I simulated an investment return analysis using a base case scenario reflecting management recently revised EPS growth guidance of 4%, 0%, 0%, 0% in 2023, 2024, 2025 and 2026 respectively and a fixed 5.7X EV / EBITDA multiple.

Summary

The risk return on BATS appears appealing as you can buy for a very cheap price 2 very strong businesses in ITC and International Combustibles plus a fast-growing Global Nicotine Non-Combustibles that should begin to start contributing to profitability as early as 2024.

The US Combustibles has been challenged in H1 2023 but should provide plenty of cash flow for years to come while the other businesses continue to grow and further increase their 64% of revenues mix.

Main risks

• US Combustibles declines further accelerates.

• International Combustible business growth slows.

• Global Nicotine Non-Combustibles business is unable to achieve acceptable profitability.

• Industry related regulatory / legal risks.

Catalyst

• Improvement in US Combustibles sales trends.

• Ability to monetize / partially monetize ITC stake.

• Achieving 2.5X Net Debt / EBITDA enabling repurchase of shares with excess FCF.