Over the past two years, the JSE All Share Index has been plagued by the collapse of several stocks which have been adversely impacted by poor corporate governance, industry disruption and an overall weak economic environment. Pleasingly, our research process has led us to avoid most of these companies including the likes of Steinhoff, Aspen, Blue Label, Resilient, Fortress and Ascendis Health as well as prevented us from holding others such as MTN in large weights.
In a particularly difficult domestic environment, British American Tobacco (BAT) has been the exception of a dominant business that we own which has performed particularly poorly. In this article we contextualise our reasoning for investing in BAT and our outlook for the company.
Background
BAT is one of the largest tobacco manufacturers in the world with a market-leading position in over 50 countries and significant presence in over 180 markets. Over the past hundred years the company has tightened its grip on global cigarette markets via a combination of acquisitions and organic growth. While global combustible cigarette volume growth has been slowing, BAT’s ability to consistently raise cigarette prices and operate with increasing efficiency has allowed it to generate and grow free cash flow over time. The investment case for BAT has traditionally relied on the company’s ability to defend market share and exert significant pricing power over its customers.
The stock’s recent under-performance is the result of both company-specific issues as well as changing industry dynamics. In particular, we find that BAT’s acquisition of US tobacco manufacturer RJ Reynolds, the advent of Next Generation Products (NGP) and a more pronounced regulatory environment in the US as being the perfect storm. Whilst we acknowledge these risks, we believe the market has been overly punitive and we see upside for the stock.
NGPs – industry disruption
NGPs include vaping products (liquid with nicotine) and heated tobacco products (tobacco stick that is heated electronically). Heated tobacco products have been particularly successful in a number of European countries as well as Japan, with Philip Morris’ iQOS leading the charge since its launch in 2014. Vaping products, often referred to as e-cigarettes, were developed in 2003 but only gained traction after 2010 as manufacturers engineered improved nicotine delivery mechanisms. In the US, vaping product manufacturer JUUL controls over 70% of the NGP market and has created a USD15bn franchise in only three years at the expense of incumbent tobacco groups. While it is not yet clear what level of cigarette cannibalisation is caused by NGPs, concerns over potential loss of business has led global tobacco groups to invest significantly in NGP R&D.
Reynolds acquisition – a game changer
In 2017 BAT completed the acquisition of RJ Reynolds, thus ensuring the US would become the group’s largest contributor to operating profits (42%). Whilst the acquisition was expensive, BAT argued at the time that the US represented one of the most profitable markets for combustibles in the world and was confident in further consolidating its position in that market. At face value, while this strategy was intended to diversify group earnings and lock-in a stable source of profits, it effectively achieved the reverse for four main reasons:
- US cigarette trends have materially worsened since 2016, arguably as a result of significant gains by competing next generation products such as JUUL.
- While the US tobacco industry is no stranger to regulatory threats, significant inroads made by JUUL among US teenagers, has galvanised the FDA’s (US Food and Drug Administration) resolve to curb cigarette consumption more broadly via nicotine reduction strategies (Nicotine Product Standard Proposal) and the proposed ban of menthol cigarettes (more later).
- BAT’s debt levels increased significantly to fund the Reynolds acquisition, forcing group gearing (Net debt to EBITDA) above 4x (1H2018) and thus reducing its financial flexibility. While we believe BAT retains the ability to service its debt, higher interest rates in the US and a weaker than expected performance from Reynolds over the medium term will likely impact the pace of de-gearing.
- Finally, the impact on group returns (ROIC) following this acquisition has been particularly negative and the deteriorating prospects may potentially result in impairments of BAT’s US business.
Regulatory environment – the FDA’s response to JUUL and menthol cigarettes
After months of speculation, in November 2018 the FDA announced that it will be pressing ahead with a menthol cigarette ban as part of a wider series of measures targeted at reducing youth e-cigarette use (caused by JUUL). While the ban is expected to be fiercely contested by tobacco companies and potentially take 3-5 years before its introduction, the loss of revenue that could stem from this ban is significant for BAT. With approximately 25% of BAT’s profitability derived from US menthol cigarettes, a total menthol cigarette ban would have a significant impact on BAT’s profits.
Outlook – where to from here?
Whilst we acknowledge that the risks to BAT’s investment case have increased over the past 2 years, we continue to believe that the group’s core combustible business still has a strong competitive advantage and will remain profitable. Our investment case is based on the following considerations:
- BAT has a dominant position in high growth emerging markets, which currently represents more than half of group profits. Medium term profitability will, in our opinion, be underpinned by continued volume growth and pricing power in these geographies.
- NGPs – We see significant upside to global uptake in NGPs and believe BAT is well positioned to take advantage of market dynamics over time. We conservatively value this part of the business but think it may well exceed expectations as this market evolves.
- In the event of a full menthol ban, we believe it is unlikely that BAT would lose all of its US menthol related revenue as we would expect BAT’s NGP and/or core tobacco channel to partially capture this business.
In conclusion, we believe that the market is being overly pessimistic on the impact of a menthol ban and the advent of NGPs on British American Tobacco’s future levels of profitability. Based on our valuation work, we believe the market is currently valuing BAT’s US business at 1/3rd of what we believe it is worth.
Figure 5. British American Tobacco Valuation. Source: Company Financials. Northstar Asset Management.