Overview 

British American Tobacco (aka BAT) is the second largest of the global tobacco firms (after PM). BAT has a market cap of ~$85b. BAT is listed in the UK (BATS LN) and the US (BTI US) and has an ADV of ~$200m between the two lines of stock. 

History 

BAT was formed in 1902, when the UK's Imperial Tobacco Company and the US' American Tobacco Company agreed to form a JV, the British-American Tobacco Company. The parent companies agreed not to trade in each other's domestic territory and to assign trademarks, export businesses and overseas subsidiaries to the JV. In 1911, the American Tobacco Company divested its shares in the JV and BAT was listed on the LSE for the first time. In 1966, BAT acquired cigar manufacturer Henri Wintermans. In 1994, BAT acquired the American Tobacco Company and its Lucky Strike and Pall Mall brands. In 1999, BAT merged with Rothmans and acquired a portfolio of several brands, including Dunhill. In 2003, BAT acquired Ente Tabacchi Italiani, Italy's state tobacco company. In 2003, BAT acquired a 68% holding in the Serbian tobacco company Duvanska Industrija Vranje. In 2004, the US business of BAT (Brown & Williamson) was combined with that of RJ Reynolds leaving BAT holding a ~42% stake in the combined entity. In 2008, BAT acquired Turkey's state-owned cigarette maker Tekel. In 2008, BAT acquired the cigarette and snus operations of the Scandinavian Tobacco Group. In 2011, BAT acquired Protabaco, the second largest cigarette company in Colombia. In 2014, BAT announced that it would invest US$4.7 billion as part of Reynolds' acquisition of Lorillard to maintain its 42% stake in the combined company. That deal closed in 2015. In 2015, BAT acquired TDR, the leading independent cigarette manufacturer in Central Europe, and the minorities in its previously-listed Brazilian subsidiary Souza Cruz. In 2016, BAT offered to buy the remaining 58% of Reynolds in a $47 billion takeover. Reynolds agreed to an increased $49.4 billion deal in January 2017 and the deal was completed in July 2017. 

Industry 

The legal tobacco industry outside China is dominated by five players – Philip Morris (PM), BAT, Altria, Imperial and Japan Tobacco (JT). The industry is the most concentrated of any major consumer good. The top five players control ~73% of the global market with that number rising to ~83% if you exclude China which is essentially inaccessible and so is the relevant scope for any analysis. The next highest category is CSDs at ~70% held by the top five players. The concentration profile is often even higher on an in-country or in-region basis. The US is dominated by three players (Altria, BAT and Imperial). The world ex US/China is dominated by four players (PM, BAT, Imperial and JT). This concentration is the result of a wave of M&A activity that has taken place over the last thirty years. BAT acquired Rothmans in 1999 before merging its US assets with Reynolds in 2004 and then merging Reynolds with Lorillard in 2015. Imperial acquired Reemsta in 2002, Altadis in 2007 and Commonwealth brands in 2007 as well as a portfolio of brands divested by Reynolds/Lorillard as a condition of their merger. Japan Tobacco acquired Gallaher and Austria Tabak in 2007. These major transactions have been supplemented by a steady stream of bolt-on acquisitions at each of these three companies to enter and consolidate smaller markets.

Business 

BAT is a pretty simple business at its core. They manufacture and distribute cigarettes from a wide portfolio of brands across a wide range of countries. The cigarette business is extremely profitable and BAT made 44% EBIT margins in 2020. This profitability has been documented and discussed ad nauseam for decades by now so I won't labour the point but if you get to turn commodity products into addictive consumables with extremely high brand loyalty and where the traditional axis of competition has effectively been outlawed and consolidation has left most markets controlled by two/three players and do it all at enormous scale, it's hard not to make money. The shareholder returns reflect this reality with Altria, BAT and Imperial generating annualized TSRs of ~14% on average from 1998 to 2018 despite that being a period of near-consistent cigarette volume declines.

BAT makes ~45% of revenue in the US, ~15% in APAC + ME, ~15% in Europe + North Africa and ~20% in the Americas + Sub-Saharan Africa. BAT's biggest single countries after the US are Brazil (~5% of revenue), Japan (~5%), Russia (~4%), Canada (~4%) and Indonesia (~3%). Those six together make up ~2/3 of BAT revenues with the last ~1/3 made up by a long tail of smaller cigarette markets. BAT has ~29% market share by value across its top forty markets and has taken share in each of the last each years (~20 bps per annum on average). It's worth noting that BAT have had a US presence for a long time but until 2018 it was via their unconsolidated 42% stake in Reynolds. Reynolds merged with Lorillard in 2015 and BAT then acquired the other 58% in 2018 for ~$50b and have since fully consolidated the US assets. This unfortunately makes looking at the reported historical results over a longer period rather messy. 

BAT makes ~90% of revenue from traditional cigarettes, ~5% from NGPs and ~5% from traditional oral tobacco products. The traditional cigarette brand portfolio includes Dunhill, Kent, Lucky Strike, Rothman's, Pall Mall, Camel, Newport and Natural American Spirit. The NGP portfolio will be covered in more detail later but covers vaping, THPs (Tobacco Heating Products) and modern oral products. The traditional oral portfolio covers mainly Swedish-style snus and American moist snuff and generates almost 100% of its revenue in the US.

BAT also owns ~1/3 of ITC. ITC was established in 1910 as the Imperial Tobacco Company of India. The company was listed in 1954, seven years after Indian independence, and has been on a gradual journey to becoming a more "local" company ever since. ITC changed its name to the India Tobacco Company Limited in 1970 and to I.T.C. Limited in 1974. ITC is the dominant Indian cigarette company today with almost 80% domestic market share and business interests in several other areas (the main three being FMCG products, agriculture, hotels). BAT has 1 board member out of 13 at ITC and the business is operated completely independently of BAT. BAT's stake is worth ~$11b at the current price of ITC and the stock is reasonably listed so there's no good reason why this isn't a fair price (~15.5x NTM P/E also seems reasonable for a business that has grown EPS at a ~12% CAGR over the last 10 years).

Thesis 

BAT's core cigarette business (~90% of revenue) is chugging along in surprisingly healthy (pun intended) fashion. The bearish takes are all focused on decades of volume declines (US cigarette volumes peaked in 1977) but the reality is more promising for shareholders. The company is indeed seeing volumes decline by ~3% per year but is also raising prices by ~5% per year such that revenue grows at ~2% per year. The company benefits from the fact that costs actually decline (with volumes) each year and so, in a normal year, incremental margins on that modest revenue growth are typically in the 110-120% range and EBIT dollars can grow a little faster than revenue. The notion of taking ~5% price per annum for the foreseeable future might seem aggressive but it's important to remember that we're talking about net pricing to the tobacco firms and not the headline price paid by a consumer. If we take the US as a case study for this dynamic, a pack of Camel might cost $6.99 while BAT's revenue will be ~$3.20 (after deducting the retailer and distributor margin as well as the state and federal excise tax). That means that if BAT raises their realised price by 5% the consumer will see - all else equal - a far more modest and sustainable ~2% increase in the price they are paying. This dynamic has enabled the US cigarette industry to take (net) prices up at a ~7% CAGR over the last 50 years. 

BAT's NGP portfolio (~5% of revenue) is covered in more depth later but has grown at a ~50% CAGR over the last three years and, in doing so, added ~2% to total company revenue growth. 

BAT's traditional oral portfolio (~5%) of revenue) has grown at a ~25% CAGR over the last three years and, in doing so, added another ~1% to total company revenue growth. 

BAT as a whole has delivered ~4% organic constant currency revenue growth over the last five years with modest price-led cigarette growth supplemented by the faster growing NGP and traditional oral portfolios. 

BAT has seen EBIT margins expand from ~37% in 2016 to ~44% in 2020 as (a) the more profitable US business was consolidated for the first time and (b) the revenues up / costs down dynamic at work with the cigarette business and described above played its part. This margin expansion has been achieved despite considerable investment in NGP R&D and S&M spending. 

BAT trades at ~7x 2021e EPS if you adjust for (a) the investments the company is making into their NGP portfolio and (b) the value of the stake in ITC. The calculation is a simple one. BAT is expected to make ~£12.5b of Adj. EBIT in 2021. BAT is losing ~£1b at the EBIT level developing, marketing and discounting their NGP portfolio in their attempt to drive share gains and carve out leading positions across their portfolio. That ~£1b number has been corroborated by most of the sell-side analysts covering the company and equates to ~£0.3 per share. The street is expecting ~£3.3 of EPS in 2021 implying that the core business is capable of delivering ~£3.6. The stock trades at ~£27.5. The ITC stake is worth ~£8b or ~£3.5 per share. That implies that BAT's core business is being valued at ~£24 per share or ~7x core EPS. There is debt here and if we make the same set of calculations on an unlevered basis, the core business is trading at ~10x EV/NOPAT. 

BAT has committed to pay out 65% of Adjusted EPS as dividends so a headline 8x P/E ratio or a ~12% headline earnings yield translates to a ~8% dividend yield.

Catalysts 

The stock is cheap but so what. The reason BAT is a compelling investment is that there are a host of inflection points on the horizon that should confluence to both accelerate EBIT and EPS growth and to create a change in the market's perception of the business. 

#1 The company will continue to benefit in H2 2021 / H1 2022 as the world returns to a degree of normalcy following COVID. Though some tobacco companies saw a tailwind from COVID as it put more dollars into their customers' pockets and WFH gave some smokers more time and freedom to smoke, that dynamic was not the case for BAT in aggregate given its large EM exposure. The company sized their estimate of the impact from COVID as having cost them 2.5% of revenue in 2020. 

#2 The company has now have passed the point of peak investment in its NGP portfolio. That implies that the shrinking losses (and eventually growing profits) from this business should be a tailwind to consolidated earnings whereas for the last ~5 years they've been a headwind. 

#3 The company will reach ~3x Net Debt / EBITDA at or around the end of 2021. This is an important milestone. There's a strangely persistent rule of thumb among traditional British shareholders than any leverage ratio that starts with a 3 (or heaven forbid, higher) is "risky" while any that starts with a 2 or less is "safe". This metaphorical line in the sand will be crossed in late 2021 or early 2022 and should erode one of the hurdles that some have to owning the stock today as well as allowing the company to begin to buy back stock in earnest. 

#4 The company got a new 7% shareholder this year - Ken Dart. I've no idea what he wants but it's logical to assume that he thinks the stock is cheap (otherwise he wouldn't own such a big slug of it, ~£4b) and that he'll be pushing management to buy back as much stock as they can once they get within their targeted leverage range around the end of the year.

NGPs 

The large tobacco companies have each, in different ways and to different extents, embraced the need to expand their horizons beyond cigarettes and towards NGPs (short for Next Generation Products). NGPs are methods of nicotine delivery that aim to avoid much of the harm that comes with actually smoking. There are three main forms today. These are #1 HTPs (short for Heated Tobacco Products), #2 e-cigarettes (i.e. vaping) and #3 modern oral products. The HTPs deliver nicotine in a similar fashion to a cigarette but without ever actually combusting the tobacco (hence the popular descriptor, heat-not-burn). The e-cigarettes produce a nicotine-containing vapour and typically don't actually contain tobacco itself (though the nicotine in the vaping liquid is often derived from tobacco). The modern oral products are nicotine pouches that are tucked under one's top lip and, unlike traditional oral products (snus, dip etc), typically don't contain tobacco. 

The dynamic around which of the three becomes the more popular NGP in a given country is driven by several factors. The modern oral products have really only taken off in countries in which traditional oral products were consumed (namely Scandinavia and the US). The vaping products dominate relative to HTPs in the US as a function of the fact that (a) the US regulatory process is particularly onerous and the FDA has yet to fully approve any HTPs and (b) the feel of the type of cigarettes that are popular in the US is less closely replicated by HTPs. In contrast, in Japan where milder cigarettes are more popular, the much lower levels of heat that an HTP uses (~150 degrees) relative to a cigarette (~750 degrees) makes for less of a flavour difference than the cigarettes that Japanese smokers are used to and Japan is the world's largest HTP market, by far, today. 

The companies each have their own strategy for and portfolio of NGPs. PM is essentially all-in on their iQOS HTP. BAT, in contrast, has several irons in the fire. BAT owns Vuse, the number two vaping brand in the US. BAT owns Glo, a distant number two to iQOS in the ex-US HTP market. BAT owns Velo, a modern oral brand that has had good success in Scandinavia but is struggling somewhat in the much larger and more important US market. Altria was slower than its peers to accept and embrace NGPs and so ended up trying to catch up via M&A, namely the strategically-sound but seemingly-overpriced JuuL deal ($12.8b for 35% in December 2018) and the Burgher Sohne deal ($372m for 80% in June 2019). Japan Tobacco has viable products in each of the three major categories but have yet to show much evidence of real product or market leadership. Imperial is the furthest behind in large part because their more tenuous starting position (from both a portfolio quality and a balance sheet standpoint) has limited their ability and appetite to reinvest cigarette earnings into the unproven, capital-intensive venture that building an NGP portfolio from scratch represents.

The investment case around NGPs gained incremental clarity when, in early 2021, PM hosted an investor day and, for the first time, disclosed that iQOS gross margins are ~10pp higher than for combustible cigarettes. The company also guided for at least 150 bps of EBIT margin expansion per annum over the 2020 to 2023 period while iQOS is expected to go from 24% to 40% of revenue. That margins are expected to expand at such a healthy clip while iQOS continues to become a larger and larger part of the mix also speaks to the fact that the margin profile of NGPs can be highly attractive. 

The investment case around NGPs has also been reinforced in recent years by the ability of incumbents to, for the most part, corner the NGP market and ensure a good chance of oligopolies emerging in these markets and more or less replicating the favourable industry structure that characterises legacy tobacco products. There are several factors that have contributed to the incumbents' ability to largely retain their positions of relevance with NGPs. They vary in importance by product and market but are typically a combination of (1) the capacity to invest heavily upfront, (2) some degree of nicotine delivery knowhow, (3) distribution capabilities and (4) regulatory barriers. On (1), Philip Morris likes to claim that since 2008, they have spent ~$8b on developing smokeless products and the main fruit of all that labour is iQOS. I'm not a smoker let alone a smoker with a passable knowledge of chemistry so how it can cost that much to design a box that heats up tobacco is beyond me but that's their claim regardless. If it's even a tenth of that amount, that's still a sum of money that I expect few would-be new entrants could raise in the current environment for the purposes of developing a cigarette-like device (tobacco is not exactly a hotbed of VC activity these days). On (2), the fact that it took so much money and the better part of a decade suggests that it is technically challenging to produce something like iQOS or Glo (BAT's competitor to iQOS) and that decades if not centuries of knowhow around designing and manufacturing cigarettes might be of some value here. On (3), the tobacco companies have broad and deep relationships with distributors and with the C-Store channel which they can leverage to ensure distribution of and shelf space for a new product in a way that a new entrant never could. This is why Altria buying JuuL made so much sense and why On! sales have exploded after Altria bought them. On (4), this is more specific to the US but there each new product must submit a PMTA (Premarket Tobacco Product Application) to the FDA which typically costs $1m+ per SKU. That's a significant upfront cost and creates another deterrent to would-be new entrants. 

It's worth flagging that, to-date, BAT's progress on NGPs has fallen short of the company's goals and they've had to reset their targets on multiple occasions. The company initially targeted (at its FY17 results) more than £5 bn of NGP revenue by 2022. The company then shifting the £5 bn target to 2023/24 at its FY18 results. Then, at its H1 2020 trading statement on June 9, the company shifted the target to 2025, citing the disruption from COVID as delaying some planned innovation and launches in the sector. That being said, this is where we are today. BAT's NGP portfolio generated ~£1.7b (~$2.4b) of sales over the TTM period. This revenue splits ~45% e-cigarettes, ~40% HTPs and ~15% modern oral. This revenue grew ~27% Y/Y (units growing ~65% but with a mix-shift to lower ASP products dragging down revenue growth considerably).  

BAT's Vuse product appears to have tremendous momentum in the US today. The product has reached ~32% value share in recent weeks (per Nielsen) and is now within reach of JuuL (at ~44%). The market also appears to stabilising from a structure perspective with the main share shifts taking place today being JuuL to Vuse but the two large players collectively now controlling a relatively consistent ~75% of the market. In the UK, Vuse has ~45% market share and I believe that Vuse is the #1 vaping product in Europe today. BAT's Glo product is still a very distant number two to iQOS but seems to be having solid traction in the markets into which it's launched thus far. In Japan, which is the world's most mature and largest HTP market, Glo has achieved ~20% volume share YTD. BAT's modern oral product Velo is their NGP with the biggest uphill battle. Though Velo has very strong market share in the Scandinavian region and Switzerland, it has struggled to put a dent into the hold that Zyn (Swedish Match) and On! (Altria) currently have on the emergent US modern oral tobacco market. The only real upshot here is that BAT knows they have a lot of work to do here and seem very focused on improving Velo's performance in the US and the success they've had reeling in JuuL in the vaping category suggests that we shouldn't write them off just yet. 

Risks 

The company is clearly on the wrong side of the investment zeitgeist. BAT has become untouchable for an ever-growing portion of the institutional investment community and may continue to derate as more and more PMs "cleanse" their portfolio of tobacco stocks. This is obviously impossible to handicap but with the stock trading at 7x core earnings and on a well-covered 8% dividend yield, I'd be surprised if the stock derates much from these levels. I could see a scenario where it never rerates from here but I think one can still do very well owning the stock on a ~12% earnings/FCFe yield and watching PBT grow at 5% to 10% over the next five years with the range of EBIT growth profiles driven by the pace at which the NGP products' margins converge to those of traditional cigarette (or don't). 

The company runs into a price elasticity wall and further price increases, even if diluted by the net/gross effect, trigger accelerated volume declines. This risk is mitigated by the fact that BAT is exposed to some of the world's most affordable markets as measured by the number of minutes of work required to buy a pack of cigarettes, namely the US, Japan and Russia. It's also worth noting some of the potentially positive tailwinds to cigarette volumes. The trend towards WFH in developed markets could afford smokers more hours during the workday during which they can smoke, should they so choose. It might sound callous to think of this as a tailwind but the reality is that that the rising usage rates of NGPs among young people could well be creating future cohorts of nicotine addicts and, as part of that, potential smokers.

The company could be negatively affected if the US regulates cigarettes more aggressively, by banning menthol and/or by raising federal excise taxes. The FDA moved to ban mentholated cigarettes in April this year. BAT stock was -2% that day. The reality is that (a) the FDA has been mulling a menthol ban for the better part of a decade but has to make evidence-based recommendations and the reason that they've not gone ahead before is that the scientific evidence to support a ban is weak (the FDA themselves have admitted this), (b) even if successful these processes take forever (5+ years in all likelihood), (c) US mentholated cigarettes are a large but manageable portion of BAT's total revenue (~20%) and (d) in other countries where mentholated cigarettes have been banned smokers tended to stick with the brands they previously used out of loyalty even as the flavour profile changed. The federal excise tax on tobacco is currently a flat $1.01 per pack of twenty. This was raised in 2009 under Obama from $0.39 (where it had been for ~25 years) and has been constant since. The fact that this tax has only been raised once in the last ~35 years gives me a degree of confidence that the base rate likelihood of it changing again in the next few years is at least low. That said, its raising would clearly achieve dual public policy goals of raising taxes (at least to the extent that such a move doesn't push more volumes to the illict trade) and reducing smoking prevalence so it can't be ruled out as an outcome. The other dynamic which has historically tempered democratic administrations' desire to raise this tax is that to do so would be highly regressive (given that cigarette smokers skew predominantly low-income) and likely very unpopular among their own constituents. That's a long-winded way of me saying I obviously don't know what's going to happen on this front - it's just a risk you have to wear in this space and I don't lose much sleep over it.