British American Tobacco Stock Analysis & Deep Dive

Close to 40% FCF yield for a non-software company

Jun 28, 2023

Intro

While my main focus is on software and tech companies, every now and then there is a company from another sector which gains my interest. In this case it is a tobacco company with a FCF margin in the high 30s. That is usually only reached by software companies.

The Company

British American Tobacco was established in 1902 and is by sales the largest tobacco company in the world. The company was born through a joint venture of Imperial Tobacco of England and American Tobacco from the US. It is headquartered in London, England but also trades on the NYSE with the ticker BTI (I will refer to the company as BTI from here onward). More than 50000 employees run the operations in more than 180 countries.

BTI has a history of takeovers with smaller ones such as Turkey's state-owned cigarette maker Tekel in 2008, Indonesia’s Bentoel Group in 2009, Colombian Productora Tabacalera de Colombia in 2011 and Croatian TDR d.o.o. Brands and Factory in 2015. The largest takeover was Reynolds American. In 2004 BTI acquired a 42% share and bought the remaning share in 2017 of $49.4bn. This brought brands such as Newport, Lucky Strike and Pall Mall to the BTI portfolio.

Formula 1 banned tobacco advertising in 2006, but since 2019 BTI and McLaren are partners and BTI is the main sponsor. BTI uses the space to advertise Vuse, its fastest growing brand.

The Industry

The global tobacco industry is estimated to be worth $935bn. With 83% of the total value of tobacco sales worldwide, traditional cigarettes dominate the market and over 2.8 billion cigarettes are consumed yearly (excl. China). Worldwide 18% of adults are smoking. Even though the cigarette market is in slight decline, the growth in next-gen products provides overall growth for the tobacco market with a CAGR of 3.4% until 2030.

The global vapour market is estimated to $55bn. BTI defines vapour as: “Vapour products are battery-powered devices that heat liquid formulations – e-liquids – to create a vapour which is inhaled”. E-Cigarettes and Vaping products are expending rapidly. For the US a CAGR of 30% is estimated until 2030.

Citi had some interesting points about the global nicotine market. I’ve highlighted those below

Some words on the ESG nonsense: Personally I find it a bit odd, that selling harmful products (I know they are less harmful than combustibles) are seen as positive factors for a good ESG score. This shows again that the whole ESG debate is sometimes quite fruitless.

The Business

In software we love reoccurring revenues. What kind of better customer is there, than the one who is addicted to your product? Welcome to the world of tobacco, a world where the health hazards have been known for decades and the customers keep on coming back. You can argue that this is as great a business model as software subscriptions.

45% of the groups revenue comes from the US, 15% from the rest of the Americas + Africa, 23% from Europe and 16% from Asia and the Middle East. 83% of BTI revenues come from traditional cigarettes, while 10% are from new categories. The rest is split between traditional oral tobacco and others.

As one expects, tobacco is a highly profitable business. With a 9% CAGR on EPS and 6% CAGR on dividends, BTI has a stong track record over the last 10 years.

Divestment of former markets continue to be expensive for BTI. The disposal of the Iranian businesses cost BTI £358m, whereas the transfer of the Russian and Belarusian business costs £612m.

This graph gives a good overview of the product portfolio of BTI. BTI really makes an effort to promote their new products and is one of the very few companies which always positions their cashcow (traditional cigarettes) at the very bottom of the list.

BTI is leading the vaping industry with a 41% market share from Vuse in 2022. This share has grown from only 25% in 2020. In terms of hardware, Vuse is leading the market with 64% volume share, which is a good indicator for future growth. On top of that the margins vaping products are even better than cigarettes. The US, UK, France, Germany and Canada make up 88% of the vapour revenues.

Vaping and THP are even more profitable than cigarettes: “So, take the example of Poland for example where margins are almost five times higher in THP than they are in Combustibles when you compare our own portfolio of cigarettes, and we migrate to our products in THP.”

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More on Vuse

Vuse is also being sold in a subscription model to the end customers. Customers save between 12 and 30% based on their consumption. This is an amazing way of cutting out the middle man and keeping more profit for BTI.

If you’re interested in what the Vuse product looks like, watch this very short video to get an idea about how it is being used:

An indication on why Vuse is so popular could be the broad range of available flavors. There are 52 different flavors including Caffe é Latte, fresh apple or Vanilla Medley. Without having tried any of these, I can imagine that they must taste a lot better than any traditional cigarette and it is not surprising that Vuse smokers are constantly vaping.

A very interesting point is, that the strong regulation over the last years has many positive effects for the incumbents:

The barrier of entry is very high due to the strong regulation
The ban of many forms of advertising actually saves the tobacco companies a ton of money, which in return they can invest or distribute via dividends.
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The Management

Before I talk about the management, I must say that the tobacco industry as a whole is not an industry of the highest ethics. It says a lot, that the controversies chapter of the Wikipedia article of BTI is the longest chapter in the whole article: https://en.wikipedia.org/wiki/British_American_Tobacco

While BTI is proud about its great ESG rating “This year alone, we received the highest award - gold class - in the S&P Global Sustainability Yearbook 2022, and were named a Climate Leader by the Financial Times.” I hope that they are wokring just as hard on lowering the crazy high litigation costs. The amount spent each year on litigation costs are quite large. In the last three years, BTI paid £943m in litigation costs.

BTI appointed Tadeu Marroco CEO in May 2023. Marroco has been with the company since 1992 and became Finance Director in 2019. The previous CEO Jack Bowles was appointed CEO in 2019 left the company abruptly in May, when BTI was fined a $635mn penalty over breaches of US sanctions on North Korea. BTI supplied the North Korean embassy in Singapore between 2007 and 2017 with $30m worth of cigarettes.

Capital Allocation

The company bought back £2bn worth of shares or 1.3% of outstanding shares in 2022 and the goal is to distribute 65% of the adjusted EPS as dividends over the long run.

“We strongly believe that share buy-backs have an important role to play within our capital allocation framework, and we will continue to keep it under review as we progress through the year.” At the same time, the CEO announced in June 2023, that there will be no more share buybacks, until the leverage has come down towards 2.5.

To quote the CEO: “Given our incremental investment plans in 2023 to further accelerate our transformation, and in light of the uncertain macro environment, higher interest rates, outstanding litigation and regulatory matters, the Board has decided to prioritise strengthening the balance sheet. This will provide greater business resilience while continuing to support future financial agility, as we aim to reduce leverage more quickly towards the middle of our target 2-3x corridor.”

I am happy, that the management is prioritizing lowering the large debt burden and therefore saving a ton of interest in the rising interest rate environment. The new CEO will follow his predecessor in terms of strategy and does not intend to make any drastic changes. New CEO Tadeu Marroco announced in June in regards to a potential change in strategy: “Will there be a change in our strategy? No. I am clear that the strategy we created in 2019 is right. I am confident that we can execute it successfully”

I love this asnwer from the CEO in the most recent earnings call in June. His focus in on the business and not the stock.

Risks

Apart from the never ending penalties and law suits, there is a risk of increased regulation regarding the vaping products. The Australian government already announced a ban on imports of non-prescription vaping products. I suspect more countries to follow with stricter guidelines since the flavored vaping products are the perfect entrance into the world of nicotine for a new generation of addicts.

The Fundamentals

Cigarette sales went down from 638bn in 2020 to 605bn units but higher prices kept the overall revenue from traditional cigarettes stable. Higher revenue from lower numbers of units sold increases the margin for these products, since the production costs also go down. While the cigarette business is slightly up over the last 3 years, the revenue in the new category segment doubled and continues to grow.

“Group revenue was up 7.7% on 2021. New Categories have become a significant contributor to this, delivering £2,894 million in 2022 (up 40.9%). We remain on track to meet our New Category revenue target of £5 billion by 2025, and now expect profitability (on a category contribution basis) by 2024, one year ahead of plan.”

This profitability will have an impact on the earnings, since this segment will add profit instead of deducting value. While BTI is claiming that losses are being reduced, they are hiding the actual losses of the new categories quite well. Or to quote BTI: “In 2022, we invested more than £2bn in New Categories to drive long-term sustainable growth, while making excellent progress in reducing operating losses by 62%.”

Some digging reveals: New Category contribution losses reduced by £578m, an improvement of 60.7%. With a revenue of £2.9bn in 2022 the new categories adjusted loss from operation was £375m vs a loss of £953m in 2021.

As of 2022: “We now have 22.5 million consumers of Non-Combustible products and revenue from these products now accounts for 14.8% of Group revenue.” In 2020 there were only 13.5m consumers of Non-Combustible products. The growth of this segment is truly astounding. The plan is to reach 50m consumers by 2030, which would be more than double of today’s number. BTI has 22 million consumers in their contactable database. This is a great treasure to promote future products to these customers.

The average debt maturity is close to 9.9 years and maximum debt maturities in any one calendar year of around £4 billion. Due to the rising interest rates, refinancing will become more expensive. This was already evident in 2022 when interest rate payments increased by 7% compared to the previous year due to higher interest rates.

In the last 5 years BTI had a FCF of £46.2bn which it used to pay dividends of £23.5bn, buy back shares worth of £2.5bn and lower the total debt by £4.9bn. This shows you what is possible with such a strong cash flow business.

Valuation

The Management announced in the most recent investor call “We continue to maintain our full year 2023 guidance” and “3-5% organic constant currency revenue growth”.

With the most recent data as of 31.12.2022 (BTI only reports annual and half-year numbers), BTI has an EV/FCF multiple of 9.4. The in absolute numbers high debt of £38bn is manageable due to the very strong Free cash flow. After dividends of £4.9bn, there are still £4.9bn of FCF left to pay down debt or to repurchase shares. As the CEO announced, the near term focus is to lower the leverage.

Considering that the new categories will be profitable from next year on, we have an additional profit (or less losses) of £375m in 2024. If the management can fulfill its promise of “we expect as a Group to generate c.£40 billion of free cash flow before dividends over the next five years” we will see a strong increase in all financial metrics. £40bn would be enough to retire all outstanding debt or to partially lower the debt and buy back shares at an attractive level.

Taken together, we have a growing business with strong cash flows at a low valuation.

Summary

British American Tobacco is at an interesting level. The old a narrative of an ever declining business has proven to be false with the rise of the new vaping products.

With a rock solid dividend yield of 8.2% (and rising) plus the low valuation of an EV/FCF of 9.4, BTI has a strong case to deliver solid returns over the next years.