British American Tobacco

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 3/5

British American Tobacco is a global tobacco company involved in the production, marketing, and sale of cigarettes, vapor products, and other nicotine products.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

British American Tobacco (BTI) operates in the tobacco industry, a market characterized by high barriers to entry, inelastic demand, and regulatory complexity.

Business Overview:

BTI operates a global business, selling in over 170 markets across four regions: Americas and Sub-Saharan Africa (AMSSA), Europe and North Africa (ENA), Asia-Pacific and Middle East (APME), and USA. Here is a breakdown of the revenues:

  • Combustibles: This segment includes traditional cigarettes, which despite volume declines, remain a significant portion of the company’s revenue. The primary brands include Dunhill, Lucky Strike, and Pall Mall.
  • New Categories: This segment includes Vapour, Tobacco Heating Products (THP), and Modern Oral Nicotine products. This segment is experiencing growth and is expected to become the core revenue source in the long term. * Vapour is lead by Vuse brand. * THP by Glo. * Oral Nicotine by Velo.
  • Other: This category is small, and includes sales of some of the company’s minor brands.

In 2021, 17% of total revenue came from non-combustible products. By 2023, non-combustible products accounted for nearly 25% of revenues. The company is accelerating its transformation journey, shifting its focus away from combustible products.

Industry Trends:

  • Declining Cigarette Volumes: The traditional cigarette market is experiencing a continuous volume decline in developed countries, though price increases can partly offset this. Growth prospects lie primarily in the emerging markets.
  • Growth in New Categories: There is high growth in next-generation products like vapor, THP, and oral nicotine, which offer alternatives to traditional smoking. This trend is driven by changing consumer behavior, health consciousness and increasingly strict regulation regarding combustible tobacco.
  • Increasing Regulatory Pressure: The tobacco industry faces ever-increasing pressure on regulation, which limits marketing and could possibly lead to a ban of some of the products in the future.
  • Shift in Consumption Patterns: There is a global shift in consumption as users seek out alternative ways of nicotine consumption and are moving to non-combustible products.

Margins and Competitive Landscape:

  • BTI operates in a high-margin business but it is highly competitive as well. There are numerous competing brands in traditional cigarettes, and this rivalry extends to next-generation products as well.
  • BTI is not among the top companies regarding profitability as it suffers from higher manufacturing and sourcing costs.
  • Other important players include Philip Morris (PM), Japan Tobacco (JAPAF), Imperial Brands (IMBBY) and Altria (MO).
  • A significant portion of revenue comes from developing countries, which exposes BTI to higher levels of volatility and risk.
  • Major players in the market have developed their own strategy to reduce risks and capitalize on the changing demand patterns.
  • The industry is facing increasing regulatory headwinds across multiple countries, which makes its future very uncertain.
In 2021, for the first time, the growth in revenues from the new categories made a material contribution to the overall increase in adjusted revenue of the group. However, as the companies shift towards new categories, they face new challenges. The regulatory environment is very uncertain for these new products and could dramatically alter their profitability.

What Makes BTI Different?:

  • Global Presence: BTI boasts a broad global reach and operates in over 170 markets, giving it a foothold in various geographies.
  • Strong Brand Portfolio: The company owns a wide variety of highly recognized brands that generate a stable consumer demand and can be used to capture the non-combustible market as well.
  • Focus on New Categories: BTI’s management has a clear intent and strategy to transform the company through new categories. This effort seems to be on the right track as reflected in the latest reports.

Financials in Detail:

  • Revenue: BTI reported revenue of £25.684 billion in 2023, down 0.4% from 2022 but at constant rates of exchange, and its adjusted revenue grew by 6.9%. The company is also increasing prices, which is partially offsetting the volume declines.
  • Adjusted Profit from Operations: The group’s adjusted profit from operations decreased to £10.2 billion in 2023, a reduction of 2.7% and an increase of 5.2% at constant rates of exchange. The profitability is impacted by a stronger dollar, losses from exiting the Russian market, and challenges in the combustibles sector.
  • Earnings Per Share (EPS): Diluted EPS increased by 6.6% to 295.6p, and adjusted diluted EPS increased by 17.9% to 346.8p in 2023. The underlying performance, excluding one-time expenses, shows growth in profits.
  • Free Cash Flow: BTI’s cash flow from operations remains resilient, even though debt is high, it is also highly predictable. In 2022, the company generated roughly £3.2 billion in free cash flow (FCF), enough to provide returns for shareholders and sustain business operations. In 2023, the company generated roughly £4.3 billion in free cash flow from operations, a major increase compared to the previous year. This increase was driven by higher profitability and lower working capital expenditure.

The revenue is mostly driven by higher prices offsetting the drop in volumes of cigarettes sold. Management has been actively improving revenue by focusing on premium combustible brands, and capitalizing on next-generation products.

  • Debt: The company is operating in a debt-heavy model with net debt at £39.2 billion as of December 2023.
    • Management expects that leverage ratios (net debt to adjusted EBITDA) will continue to decrease through 2024.
  • Dividends and Share Buybacks: BTI aims to provide steady dividends and plans on share buybacks.
    • The board has announced a share buyback program of £700m which was completed at end of 2022.
    • The company has announced a new buyback program for roughly £1.6 billion, starting Feb 2023 for a year.
    • Also, the dividend was raised by 6% to 230.9p per share in 2023.

The company is trying to lower its leverage and financial risk. BTI has a strategy to achieve this through increasing cash flows, controlling debt maturities, and improving capital allocation.

Moat Analysis:

BTI’s moat is assessed at 3 / 5 due to the following factors:

  • Brand Strength: BTI owns a portfolio of well-known brands like Dunhill and Lucky Strike that have developed a high consumer loyalty and a history of sales performance. These brands do have a strong presence globally and can contribute to pricing power which is very important in the tobacco industry. This is a strong moat source, providing steady revenue streams but is also vulnerable to the changing trends that favor new product categories.
  • Economies of Scale and Distribution: The company operates on a global scale with strong and extensive distribution networks. These create some barriers for new entrants, which provide BTI a degree of advantage. However, there is fierce competition among companies in this industry, which prevents it from translating into high pricing power.
  • Regulations: The industry is heavily regulated with high barriers to entry. The regulation, which appears as a risk for many of its competitors, is also a moat for BTI as it is a well-known company, with plenty of experience in this complicated industry. However, regulators are also turning towards new categories of products, which could negatively affect future profitability.

The company faces major risks from changing consumer behavior, regulations regarding tobacco and nicotine, and the shift towards new categories. It needs to focus on innovation, and building brands in the new categories to maintain a durable moat.

Legitimate Risks That Could Harm the Moat & Business Resilience:

  • Regulation: Increasing regulation, especially those targeting new categories (vapor, THP), could limit growth opportunities. For example, the menthol ban in many regions could hurt sales of menthol cigarettes. Also, taxation and pricing laws can change in multiple markets, which would hurt the overall profitability.

  • Changing Consumer Trends: The continued shift away from combustible tobacco and towards alternatives is a major threat to revenues from the traditional business segment.

  • Market Consolidation: Consolidation of both suppliers and customers could squeeze margins.

  • New Technologies: New advancements can create alternatives and challenge the new categories of products.
  • Brand Perception: A poor reputation is a major risk, as tobacco products in general are already stigmatized. A large negative event could further worsen perception among stakeholders and consumers.

The company is taking steps to reduce the risks by diversifying revenue streams. While there is some progress, it is a long way until the company has transformed fully into next generation products.

Understandability: 2 / 5 The company’s business model is complex. While it seems simple on the surface-as in selling cigarettes-the details of the regulatory environment, taxation and compliance are very complicated. Also, the company is a multinational firm with a diverse product portfolio which adds to complexity. The business operations of the company can be hard to understand by an outside investor as the financial reports can be very complicated to decipher due to the various accounting standards that can be implemented in various different markets, the complicated tax laws, the numerous litigations etc.

While the company is transforming into new product categories, there are a lot of factors influencing its future which are hard to predict.

Balance Sheet Health: 3 / 5

BTI is in moderate shape regarding its balance sheet health. While it has a huge asset base and very reliable cash flows from operations, it also has a significant debt pile which can pose a threat, especially during hard financial times. The company is showing improvements in its leverage ratios and has strong cash flows to cover for the interest payments. However, a few more years will be needed to bring down the debt to reasonable levels. Overall, the company is in an OK position to continue its operations and make investments in the business.

BTI is a company with a complex yet established business model. It has a relatively durable moat and operates in a regulated industry. However, it faces risks from changing consumer behavior, new technologies, and more stringent regulation. It generates high cash flow and the board is focused on delivering value to shareholders through dividends and share buybacks. Due to all these factors, it can be attractive to investors who are seeking stable returns, however, risk is an important factor that should be considered.