British American Tobacco (BAT) is one of the world’s leading tobacco and next-generation product (NGP) groups managing an extensive portfolio of brands. It has delivered earnings growth of over 10% per annum in constant currency over the last decade, a feat that ranks with the best in global staples. Shareholders have been rewarded with a dollar return of 9% per annum over this 10-year period, strongly outperforming the MSCI World Index return of 6.5% per annum over the same period. This excellent track record has been achieved despite severe tightening of smoking regulations around the world. Not many businesses can operate, let alone thrive, in the midst of unfavourable regulations that include bans on public smoking and advertising, and plain packaging (effectively a ban on branding). BAT’s performance is testament to the robustness of its business model.
There are not many businesses with true pricing power. BAT has the ability to pass through pricing ahead of inflation significantly more than the average company due to the addictiveness of its product. Pricing is a key lever needed to offset declining volumes caused by fewer smokers. Regular increases in excise/sin taxes also contribute to frequent price increases being passed on to consumers. Over the past decade, BAT has been able to generate, on average, 6% per annum in pricing, resulting in low to mid-single digit revenue growth.
MARKET SHARE GAINS, COST SAVINGS AND MARGINS
BAT has consistently gained market share over the last seven years, driven by its strategy of pushing through global drive brands (GDBs) to replace a plethora of local brands with less market appeal. GDBs include familiar brands like Kent, Dunhill and Rothmans. GDBs have grown at 7% to 8% per annum and constitute over 50% of total volumes. The process of consolidating the brand portfolio around GDBs comes with massive synergies in areas such as advertising, supply chain and complexity reduction in manufacturing. The implementation of enterprise resource planning system SAP has resulted in additional cost savings, leading to annual margin expansions and consequent mid-high single-digit operating profit growth.
EXCELLENT CASH GENERATION AND CAPITAL ALLOCATION
BAT has low capital intensity, which when coupled with high margins results in good free cash flow conversion. This free cash has been used to reward shareholders with high payout ratios coupled with periodical share buybacks. Significant acquisitions have been largely of businesses in which BAT already had a stake, which reduces the associated risk considerably.
BAT acquired 58% of the stake it did not already own in Reynolds American Incorporated (RAI) last year. RAI is the second-largest tobacco company in the US with a 35% share of the market, behind market leader Altria, which owns the popular Marlboro brand. This deal makes BAT the largest tobacco company in the world.
We believe this is a company transforming transaction for BAT, providing it with access to the third-biggest, most profitable and one of the most affordable tobacco markets in the world. RAI has much room to increase prices without making cigarettes in the US too expensive. There are also significant cost and revenue synergies from combining the two businesses, and it gives the kind of scale required to invest in NGPs.
NGP OPPORTUNITY HAS POTENTIAL TO STEP CHANGE EARNINGS BASE
BAT has made significant investments into NGPs, a term used to describe various smoking devices that seek to deliver nicotine and other flavours in ways that are safer than combustible cigarettes. These can be grouped as heat-not-burn and e-vapour products; the key difference is that the former heats up actual tobacco while the latter heats up liquid/salts. The NGP category is growing rapidly across the world (forecast to be a £30 billion market by 2020). The US has the largest e-vapour market and Japan the largest heat-not-burn market. Due to a combination of premium positioning and favourable tax treatment, these products are two to three times more profitable than normal cigarettes. BAT is currently rolling them out aggressively across 14 countries. We believe these products could add at least 15% to BAT’s earnings base over the next five years.
FOOD AND DRUG ADMINISTRATION (FDA) CONCERNS
BAT’s share price has come under a lot of pressure in recent months, more so than its competitors. Besides the rising global bond yields, which have put pressure on most global staples, BAT is facing an uncertain regulatory environment in the US, its largest market. However, given improvements in NGP technology, there is now an alternative to smoking for those who still want nicotine.
The US FDA is starting a comprehensive process that seeks to develop a product standard for combustible cigarettes. Its aim is to reduce nicotine levels in combustible cigarettes to a minimally addictive/non-addictive level. This has the market worried. However, our research suggests that the science supporting any level of nicotine as non-addictive is still very weak at best. In addition, economic effects such as the impact on various state tax revenues and the possible growth of illicit markets will still need to be determined over the next few years. Compared to other markets, US tobacco nicotine content levels are an outlier and could be reduced considerably without affecting the market significantly if effected in a phased approach.
The FDA is also considering regulating flavours in smoking products, including menthol in cigarettes. The intention is to investigate whether certain flavours make it more likely for youth to start the habit of smoking. Menthol cigarettes make up a quarter of BAT’s revenue; any ban would therefore be extremely negative. However, the tobacco industry has been down this road before in the US, where a ban on menthol was considered through a process that began in 2011. The attempt was unsuccessful, and there have been no significant scientific developments since then that lead us to believe that a different outcome is likely.
BAT has delivered considerable value for its shareholders over a long period, despite operating in a very closely regulated industry. The tobacco industry has very attractive fundamentals, including pricing power, margin expansion opportunity, strong free cash flow conversion and high returns on investment. With its attractive profitability and positioning, the NGP opportunity has the potential to step change BAT’s earnings base. The current uncertainty over potential changes in the US regulatory environment, led by the FDA, has been priced into the current BAT share price. We believe exceptional global staples (for example, Unilever and Nestlé) should be valued at 20 to 22 times multiple to normal earnings. Given the regulatory risks that the tobacco industry face, we discount this multiple by 15%, which is why we value BAT at 18 times multiple to its normal earnings. BAT currently trades at 10.4 times multiple to our assessment of normal earnings, which in our view significantly undervalues the business.
Disclaimer: As long-term investors, environmental, social and governance (ESG) considerations are fully integrated into our investment process and form part of the mosaic for any investment case, in understanding the long-term sustainability of companies and their business worth. When valuing a business, we take ESG factors into account predominantly by adjusting the discount rate applied to the assessment of its normalised earnings. We therefore implicitly build the risks relating to ESG considerations into the ratings of the businesses we analyse. Where we can, we explicitly allow for ESG costs in the modelling of a company’s earnings. Social objectives vary significantly between investors, and ESG issues are often intrinsically fraught with ambiguity. We do not exclude investments in companies that perform poorly on ESG screens, but we do require greater risk-adjusted upside before investing. In practice, a business with an ambiguous ESG profile will be required to deliver higher returns to justify its inclusion in the portfolio.