BTAFF - British American Tobacco: A Great Play In The Tobacco Space

2023-11-14 12:28:35 ET

Summary

• British American Tobacco p.l.c. is a large tobacco company with a market capitalization of $69.1 billion.
• British American has embraced significant change and invested in growth initiatives, including non-combustible products like vaping and tobacco heating products.
• Despite declining tobacco volumes, British American revenue, profits, and cash flows are all up, and the company is expected to continue growing its new categories.
• Add on top of this robust distribution coverage and attractively priced shares and it's definitely worth consideration.

On a personal level, I am not a fan of tobacco or tobacco products. But just because I don't like something doesn't mean that it doesn't make for an interesting investment prospect. The fact of the matter is that some of the most questionable or objectionable companies offer up the best opportunities for investors.

A good example of this can be seen by looking at British American Tobacco p.l.c. ( BTI ), one of the largest tobacco businesses on the planet with a market capitalization as of this writing of $69.1 billion. Although tobacco volumes continue to decline across the globe, there have been a number of changes in the industry that have opened up the door for growth for the companies in this space. Add on top of this how cheap shares of these businesses are, and it is difficult to be anything worse than bullish about them.

An important note

In its financial statements, British American Tobacco refers to all of their financial data in the form of pounds as opposed to U.S. dollars. For the purpose of this article, I have translated all currency amounts into dollars utilizing the current exchange rate.

A major transformation is occurring

For those who are not terribly familiar with the tobacco industry, it may seem like a low-tech market that is destined for long term decline. I think that would be an appropriate description for traditional tobacco products. But in recent years, the industry has embraced significant change and made investments aimed at structuring their operations for the long haul. At the forefront of this change is British American Tobacco. Before we dig into why British American Tobacco makes for an appealing prospect, we should first come to understand what the company is today and what it is turning into.

Operationally speaking, British American Tobacco has five different categories of products. The oldest and most traditional of these categories is what management calls Combustibles. This really consists of the cigarette sticks and similar products that the company sells in over 170 markets utilizing 41 integrated cigarette manufacturing facilities. Using data from 2022, this is still the largest part of the company, accounting for 83.3% of sales. It is also the part of the firm that has faced the greatest struggles in recent years.

Globally speaking, the combustibles market is massive. The legal side of that market is estimated to be worth $935 billion, with cigarettes accounting for 83% of that value. An impressive 18% of the world's adult population is classified as smokers. Even though this industry is massive, it is gradually declining. Last year, for instance, British American Tobacco sold 605 billion cigarettes. That was down from the 638 billion reported only two years earlier. And during the first half of the 2023 fiscal year, the company reported the sale of 286 billion cigarettes, which was 5.7% lower than what the enterprise reported during the same window of time last year.

If this were the only line of business that British American Tobacco was focused on, I would encourage you to look elsewhere for opportunities. After all, this is an industry that is destined to die. But the good news for shareholders is that management has been very proactive and has invested heavily in growth initiatives. This leads us to the other four categories worth mentioning. Next in line, we have the Traditional Oral category, which includes snus and snuff, the former being a moist form of oral tobacco from Sweden and the latter being tobacco that comes in loose form or as pouches. These products are typically mixed with water, salt, and aromas.

On its own, this is the third largest category for the company, accounting for only 4.4% of sales last year. And it's not even a new category. Despite this, it continues to see growth at a rate that comfortably outpaces the growth seen by the Combustibles category. From 2020 through 2022, revenue growth for Combustibles was 1.2%. By comparison, the Traditional Oral category grew by 4.2%. But once we get outside of this category, we get into the three categories that management describes as the New Categories for the company. These are the Modern Oral, THP, and Vapour categories.

The first of these, Modern Oral, is the smallest of the five, accounting for only 1.4% of the company's revenue. These are products that are smoke free oral nicotine in nature. As the name suggests, they are for oral consumption. In short, consumers put a disposable nicotine pouch between their gum and upper lip where both the nicotine and any flavors combined with it can be released and nicotine can be absorbed into the mouth. Although this may not sound like a particularly interesting growth avenue, revenue over the past three years has grown by 101%. Next, we have the THP category, which refers to tobacco heating products. This is a newer line of business that involves the user heating, as opposed to burning, their tobacco in order to create an inhalable aerosol that has nicotine in it. The specific brand name that the company sells these devices under is glo. Revenue under this category accounted for only 3.8% of overall revenue for the company last year but sales have been up 67.2% over the past three years.

And finally, we get to the most interesting and exciting part of the company. If you haven't guessed by now, that's okay. It's the Vapour category. Using handheld, battery powered devices that heat a specific liquid, an inhalable aerosol is produced for the consumer. This is most commonly known as vaping. You might not know the specific vaping devices that the company makes by its own name. But you almost certainly know of the devices based on their brand name for them. And that is Vuse. And even though it accounted for only 5.2% of the company's revenue last year, sales have actually shot up by 135% from 2020 through 2022. This is, according to management, a truly excellent growth opportunity for the company. Even though the THP market is estimated to be worth $29 billion, the vapour market is worth around $23 billion today. Management does look at these new categories, as well as the Traditional Oral category, altogether as part of the RRP (or reduced-risk products) space. And the market opportunity under this umbrella is quite material. According to their own estimates, the RRP market should see growth of around 500% between 2021 and 2026.

Over the past few years, British American Tobacco has seen some rather attractive growth in terms of the number of consumers willing to buy its non-combustible products. This number jumped from 13.5 million in 2020 to 22.5 million in 2022. A lot of that growth came from the Vapour category, with the company selling 612 million 10ml units/pods in 2022, which was up from 344 million two years earlier. Meanwhile, the number of THP sticks groove from 11 billion to 24 billion while the number of Modern Oral pouches jumped from 1.93 billion to 4.01 billion. And when it comes to the 2023 fiscal year, the data continues to look encouraging. Even as Traditional Oral volumes are down 15.9%, Vapour volumes are up 9%. Modern Oral pouch sales have skyrocketed 32.7%, while THP sticks volume has increased by 9.8%.

Despite continued weakness from a volume perspective when it comes to the company’s Combustible products, overall revenue has risen from $31.67 billion in 2020 to $33.98 billion in 2022. Net income has grown from $7.86 billion to $8.19 billion. As you can see in the chart above, operating cash flow and adjusted operating cash flow have both grown during this window of time as well. The only profitability metric to worsen during this period of time was EBITDA. It managed to drop from $16.28 billion to $15.09 billion over a three-year window.

When it comes to the current fiscal year, things are looking up across the board. Revenue, profits, and cash flows, are all up year-over-year. And that trend can be expected to continue for the near term. Management claimed that while global tobacco volumes are expected to drop by 3% this year, it is forecasting organic constant currency revenue growth of between 3% and 5%. The company also believes that it remains on target to grow its New Categories to £5 billion in annual revenue by 2025. That would imply an increase of over 40% compared to what was seen in 2022.

In addition to growing, the company continues to be in a position to pay out an attractive distribution. Last year, for instance, it allocated $6.23 billion toward dividends. This has resulted in a yield as of this writing of 9.17%. The good news is that the company has fantastic coverage. Distributions absorbed 49.8% of the company's adjusted operating cash flow last year. And for the first half of this year, they absorbed 48.4% of it. On top of this, shares of the business are rather cheap. Based on my own estimates, the firm should generate around $8.60 billion in profits this year. Adjusted operating cash flow should be around $13.14 billion, while EBITDA should come in at around $15.85 billion.

Using these numbers, I then created the chart above. That chart values the company based on those estimates and it values the company based on results from last year. As you can see, the company is trading in the mid to high single digits on a forward basis. I also, as part of my analysis, compared it to four similar firms that are also quite large in this space. In the table below, you can see that when it comes to both the price to earnings approach and the price to operating cash flow approach, British American Tobacco ended up being the cheapest of the group. And when it comes to the EV to EBITDA approach, only one of the four firms was cheaper than it.

Takeaway

Based on all the data provided, I would say that even though I am not a fan of the tobacco space and would never personally invest in it, British American Tobacco is a prime prospect for investors who do or will. Shares are cheap and management is investing in the future of the industry. Although it will still be quite some time before the company generates most of its revenue from these newer offerings, that day will likely come. And when you factor in these growth initiatives with the strong cash flows the company already gets from its legacy operations, and factor in just how cheap the stock is on both an absolute basis and relative to similar firms, it becomes clear to me that this is a very solid ‘buy’ candidate at this time.

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