British American Tobacco: Priced For Decline But I Think It Will Grow (NYSE:BTI)

Why investors buy tobacco stocks… and why some don’t

The tobacco industry is known for a lot of favorable investment attributes. Since you’re following British American Tobacco p.l.c. (NYSE:BTI), I probably can’t name one you don’t already know: High dividend yields, high gross margins, low P/E ratios, share buybacks, high returns on capital, strong customer loyalty. You name it.

With these attributes evidently present, a relevant question is: Why isn’t everyone buying these stocks? Aside from the ethical dilemmas keeping some institutional investors away, I think the elephant in the room is the general perception of the industry’s future prospects.

Here are some 2023 news headlines to illustrate this point:

With bad news and public scrutiny over the industry just as evidently present as the favorable investment attributes, I guess in general it’s fair to say that the market expects those attributes to wither away eventually. If the general market is right in this assessment, it leaves the tobacco industry in the same basket as the newspaper industry: A “has been” which used to boast high returns on capital, strong brand recognition and loyalty, monopoly-like markets, etc., but now has trouble even making money at all.

The industry appears painfully aware of its own problems, however. Tobacco companies are generally transitioning their businesses to non-combustible products. The question is what exactly that means to these businesses, and whether this is going to return the industry to years of growth.

I’ve done extensive research on Altria (NYSE:MO), and I covered BTI in part in a previous analysis. With that particular analysis, I concluded that BTI was the second-best investment of the industry based solely on statistical metrics.

This time, though, I’ll do a deeper dive on BTI’s attempt to transition their business in the hopes of giving you a better understanding of exactly what the business holds going into the future.

A Better Tomorrow: Let’s hope it is for the stock

BTI’s stock has been battered this year. It’s down ~22% from the onset of 2023. Even the healthy dividend of ~9% doesn’t do much to counter this price action.

At a P/E of ~7, clearly the market doesn’t anticipate much in the way of growth at this point.

Management is trying to reverse the situation. BTI’s corporate strategy is labelled “A Better Tomorrow”, and the mission statement reads:

We have a clear purpose to build A Better Tomorrow™ by reducing the health impact of our business. Put simply, smokers must have access to better choices.

The statement appears all about transitioning the product portfolio from combustible tobacco products to alternatives.

The company does appear to be making progress along those lines, having increased the number of non-combustible product customers from 13.5 million in 2020 to 22.5 million in 2022:

BTI had started the transformation in 2013 with the launch of their first Vapour product in the UK. Since then, BTI has consistently taken new alternative nicotine products to market:

Click to enlarge

As it follows from the table, BTI’s main alternative product brands are now:

In spite of having made these substantial efforts in transitioning, the vast majority of BTI’s brands are still legacy brands, mostly of cigarettes. These include global brands and local brands, some of which are:

• Lucky Strike.
• Pall Mall.
• Benson & Hedges.
• Prince.
• Viceroy.
• Winfield.

Hence, the vast majority of BTI’s revenues and earnings still come from combustible products.

In its annual report 2022, BTI describes how they have identified some combustible brands to be “strategic”. It is also described how – in spite of wanting to transition – BTI remains focused on growing these strategic brands. These include:

• Dunhill.
• Kent.
• Lucky Strike.
• Pall Mall.
• Rothmans.
• Newport (US).
• Natural American Spirit (US).
• Camel (US).

The said “strategic brands” account for 66% of BTI’s combustible volume. From this I understand that BTI’s overall strategy isn’t really to completely transform all product categories, but perhaps rather to transition most of its brands to alternatives, with some still significant portion of its earnings and revenue coming from strategic brands even in the distant future. Perhaps this would then leave BTI divesting some of the smaller and less strategically important brands to focus on alternatives and strategic brands.

It follows from the above that in the coming years, I believe BTI’s corporate strategy will unfold as follows:

• The alternative brands – Vuse, glo, Velo – will continue to grow, and we will see BTI relying on non-combustible brands more and more for revenue and earnings
• New alternative brands are likely to be developed or purchased from others to further strengthen the transformation
• The strategic brands of combustible tobacco will remain part of BTI and continue to be drivers of revenue and earnings for several years to come
• Some less strategically important brands could potentially be divested to focus more on strategic brands and to further transform in relative numbers. I should stress that there are no indications at this point that BTI considers this move. It’s one I personally see fit as a natural follow-up on the strategy laid out by management

Whether BTI’s strategy will succeed obviously remains to be seen. One thing of particular importance going forward from here is whether BTI will only transition their customers from A to B (from combustibles to non-combustibles), or whether they will actually be able to grow their customer base as a whole once most customers have transitioned. Perhaps this would come from less regulatory scrutiny over BIT’s products once they are mostly less harmful alternatives. If so, this would greatly benefit the value of BTI which I will be discussing next.

What transitioning the business could be worth to you as an investor

It’s pretty evident that not much growth is priced into BTI at a market price of ~7 times earnings. As a matter of fact, with that multiple, I think it’s fair to assume that the market expects negative growth from BTI.

If BTI transitions successfully – that means going from a part combustible, part non-combustible product portfolio to a mostly non-combustible product portfolio – I think there’s a chance we’ll see at least some revenue and earnings growth over time. There’s even a chance that transitioning to alternatives could help BTI not rely on “price elasticity” as much as it has (along with other tobacco firms).

Price elasticity is a measure of how sensitive the demand for a good is to the price of that good. All goods react to price changes to some extent. A price increase will in most cases result in lower demand. The price elasticity of that good then measures how much demand will drop given a particular price hike. This is essential to the tobacco industry because the industry has been relying on price increases to offset the general decrease in demand. Now of course those price increases lower demand even more – but the trick is to monitor and control those price increases and the resulting decrease in demand (elasticity) just enough to get it just right. To hit the sweet spot between raising prices enough to keep growing, but enough to bring demand out of balance.

If BTI’s product portfolio in time consists mostly – or perhaps even almost entirely – of alternatives that are less harmful than legacy tobacco products, I think there’s a chance BTI will rely much less on having to increase prices and get the “price elasticity game” right. That makes it easier to grow.

If BTI hence is able to show just a few percentage points of growth a year, I think we could easily see the market ascribing a P/E of 10 or so, perhaps even more. And if so, it appears the market is mispricing BTI by a relatively comfortable margin of safety.

The risks of BTI’s strategy

So I think it’s pretty safe to say that BTI will eventually transition to mostly providing alternative tobacco products. The regulatory winds are blowing in that direction, and the company remains fully focused on the objective.

But if the public scrutiny over tobacco continues – even after a transformation to alternatives – perhaps the regulatory environment will not ease and the market’s perception of the industry continue to be that tobacco stocks are “dead meat”. If so, investors are left with the dividends which are healthy but not enough to counter negative price action and not enough to beat the market. I think this is the greatest risk involved with investing in BTI today.

Then of course there’s the competition. To a large extent, I think BTI has just one true competitor: Philip Morris International (NYSE:PM). This is the only other tobacco company operating in a similar amount of countries with a similar amount of brands. Philip Morris is widely considered a leader in transforming its business to alternative products.

Key takeaways

BTI’s stock has been battered recently. This appears to be reflecting the market’s anticipation of stalling or negative growth.

BTI is doing a lot to transform its product portfolio from combustibles to non-combustibles, however. It appears to be working as the company has just about doubled its non-combustible consumer base in the past few years. BTI has said themselves that they will also focus on select strategic legacy brands. This should keep the company making enough cash to afford the transition.

The combination of a sustained focus on select strategic legacy brands and a continued effort to transform the business I believe will keep BTI growing in the low single digits. If this holds true, the stock appears somewhat undervalued as I believe a P/E of about 10 more accurately reflects low-single digit growth for this type of mature company. I believe the main risk associated with this investment thesis is that some change in the regulatory environment is also probably needed to change the market’s perception of the industry (i.e., easing of public scrutiny). However, with a strong transformation and industry innovation to drive less harmful alternatives, this could be the future.

For the reasons stated above, I rate BTI a Buy.