British American Tobacco (BTI - BATS)
Another cigar butt with a free puff
Key Data
Name: British American Tobacco (BTI - BATS)
Sector: Tobacco
Share Price: 23.92 £
Dividend: 2.3552 £
Market Cap: 53 Billion £
Areas of Operation: Worldwide
Business:
British American Tobacco p.l.c. engages in the provision of tobacco and nicotine products to consumers worldwide. It also offers vapour, heated, and modern oral nicotine products; combustible cigarettes; and traditional oral products, such as snus and moist snuff. It also distributes its products to retail outlets. British American Tobacco p.l.c. was founded in 1902 and is based in London, the United Kingdom.
This is a large multinational corporation, and one of the largest in the world in terms of tobacco. They operate in essentially every country on earth, with only a few notable exceptions (Russia and Belarus, Iran, North Korea, etc…).
They have significant market shares in most of the countries they operate in, and they possess many highly valuable brands like Lucky Strike, Camel, Vuse, etc…
Its main competitors are the other multinational tobacco giants, Phillip Morris, Altria, etc…
The company has 3 main regions:
US
45% of revenues
Includes only the USA
AME
36% of revenues
Includes all other countries in the western hemisphere plus Europe
APMEA
20% of revenues
Includes Africa, Asia and Oceania
Their joint partnership in India has been sold off recently.
Additionally they split their product categories in the following way:
Combustibles
This is your standard cigarette sticks that you can find in supermarkets, stores, gas stations, etc…
The Group sold 555 billion cigarette sticks and 15 billion OTP (stick equivalents) in 2023. The Group operates internationally, with 38 fully integrated cigarette manufacturing facilities in 36 markets.
This corresponds to about 80% of revenues, and substantially all profits.
Traditional Oral
Traditional Oral products include snus and snuff. Snus is a moist form of oral tobacco originating from Sweden. It is available in loose form or as pouches. The tobacco is typically mixed with water, salt and aromas.
This corresponds to about 4% of revenues, and while the segment is profitable, the margins here aren’t as good as combustibles.
New Categories
This is further split into 3 categories, and represent their new “growth” products that they are trying to create a market for.
This corresponds to about 13% of revenues (and growing), and the segment is around break even, though they hope to make it profitable soon.
Vapour
Vapour products are battery-powered devices that heat e-liquids to produce an inhalable aerosol, commonly known as vapour. Although e-liquids usually contain nicotine, there is no tobacco in Vapour products.
Heated Products
Heated Products (HPs) comprise two main functional parts; an electronic handheld device that contains a lithium-ion battery that powers a heating chamber: and a specially designed consumable that is inserted into the device. Everything has been designed so that nicotine and flavour are released through precision heating.
Modern Oral
Modern Oral products are pouches which contain high purity nicotine, water, and other high-quality ingredients. Consumers place the disposable pouch between their gum and upper lip, typically for around 30 minutes, during which time nicotine and flavours are released and the nicotine is absorbed through the tissues lining the mouth.
Important Notes
Background
This is a huge business that has been looked through by every equity analyst under the sun, so it’s not the type of investment where anyone has any significant hedge, or new information they can bring to the market price.
I have no illusions that I know better than the market here, nor does my investment thesis require that.
Fundamentally this investment has 2 core factors:
Tobacco is a sin industry, and I mean to collect a premium for investing in an industry where certain investors are unwilling or unable to invest in. The fact that tobacco generally has favorable unit economics, and low CAPEX requirements is a bonus there.
The company recently reported a massive impairment on an acquisition they did years ago. This has meaningfully depressed their earnings, and the stock price tanked as a result. I don’t believe this impairment will meaningfully reduce their future cash flows, so I mean to take advantage of this temporary discount.
That’s basically it really.
The company generates cash flows, it’s returning them to shareholders, and the impairment plus the fact that is in a sin industry means it’s valuation is depressed, providing me greater “bang for my buck”.
I pretty much expect the company to remain stagnant (as it has remained for the past decade), and effectively slowly shrink in inflation adjusted terms. If the new products are a success, and they manage to make them profitable and have them generate large revenues, then great, but that’s not really key to the thesis.
Key Indicators:
Revenue Growth CAGR: 2%
Net Margin: 27%
Return on Assets: 5%
Return on Operating Capital: 34%
Return on Equity: 9.7%
Debt to Assets: 46%
Book Value per Share: 33.91 £
Cyclicality: Cyclical
Expected State: Shrinking
Current Valuation:
Price to Earnings: 7.3
Price to Book: 0.7
Price to Tangible Book: —
Price to Revenue: 2
Shade Research Valuation:
Assumptions:
Discount Rate: 10.2%
Nominal Revenue Growth: 0%
Expected Price to Earnings: 8
Expected Net Debt to Adjusted EBITDA: 2.2
In my model I assumed that the company would have essentially 0% revenue growth, with net margins going down over the next 4 years before returning to its current values by 2030.
The reason for the decrease in the net margin during this time period is the result of higher financing costs as they have to refinance their existing debt at higher rates.
That said I suspect that I may be over-estimating this impact, since only about half of this long term debt will need to be refinanced. Furthermore I expect half of that debt that will be upcoming in the next 6 years will be paid off without refinancing at all.
I also checked the yield curve on USD denominated debt, and used that to estimate the change in the refinancing costs over time, when using a 2% risk premium.
Overall I expect that from 2024 to 2030 a total of 8 billion pounds of debt will be retired, contributing to a reduction of net debt to adjusted EBITDA to 2.2, on the low end of the management teams target range.
I think this is doable, and will likely be higher if financing costs are lower.
I assume that they will continue to raise dividends at 1 penny per year, and that they will pause all buybacks.
This last bit might not be reliable though, since they have already returned to conducting buybacks following their divestiture of the India joint venture.
That’s ok? They are paying almost a 10% dividend yield at this time, so buying back shares arguably does more to reduce their financing costs than paying off debt? Assuming they don’t want to cut the dividend, which seems reasonable to me.
I also calculate a CAPM discount rate of 7.22%, using a weighted average of USD and GBP risk-free rates, and a 0.25 beta. I bump that up by 3% to increase the margin of safety and account for the company’s real growth (or lack of it), hence the 10.2% discount rate.
Results
Given my assumptions I estimate a net present value of an investment in BTI of around 25.65£ per share, about 7% higher than the current share price.
This isn’t a big premium, but I think that there isn’t much possible downside here.
The multiple I’m paying is low, and the business itself is stable and profitable.
Additionally they pay a juicy dividend, which means I’ll be seeing my cash coming back relatively quickly, reducing my risk over time.
This isn’t going to 10X, nor is it particularly undervalued, but I think it’s got an attractive risk/reward ratio.
So I’m calling this a Buy.
I had to choose between buying the shares on the London Stock Exchange, or the ADR in New York (The South African market was not in consideration).
Ultimately I chose the ADR in New York due to reduced transaction costs (even after the ADR fee I’m better off), so I am currently a proud owner of 120 shares of BTI, and have sold 2 puts with a strike price of $30 per share and an expiry date of july 19th.
I might increase my position more in the future.