PHILIP SHORT: Scratching below the surface of tobacco companies

Consumers’ first thoughts on tobacco companies are generally “unhealthy; addictive; money machines”. As an investor one thinks “overreaching regulation; a dying industry; money machines”.

These are unenviable characteristics one would usually prefer to avoid ... except that money-machine trait. That’s interesting enough for us to want to scratch below the surface. 

Regulation is the biggest red flag when looking to invest in tobacco companies. Regulators dictate what products tobacco companies may and may not sell, and governments can increase taxes on tobacco products to the point where they become unaffordable.

One of the more stringent regulators is the US Food & Drug Administration (FDA). This is a cause for concern by British American Tobacco (BAT) investors because the FDA has flexed its muscles over tobacco of late, and 40% of BAT’s revenue is derived from the US.

How did the US become such a large percentage of BAT’s revenue? The group used to own 42% of Reynolds American (the vehicle through which it had exposure to the US), and bought the remaining 58% in 2017. Looking at the price points of cigarettes worldwide in dollars versus GDP per capita, it is clear that affordability still has far to go in the US. 

BAT’s operating profit margins are higher in the US, at 54% versus the 44% group average. While volumes of traditional smoking products — combustibles — are expected to decrease, the favourable pricing environment will more than offset this for at least the medium term.

However, we would like to see something more tangible, beyond the medium term, than the combustible portfolio now offers. What happens one day when combustible prices are too high and unaffordable and volumes too low? How far will regulation go? How are tobacco companies positioning themselves for this? 

The effects of regulation, and the unquestionable evidence of the harm combustible products inflict upon users, has pushed tobacco companies towards next-generation products. BAT and Philip Morris International are leading the way when it comes to reduced risk products: 

• Vapour or e-cigarettes. Vaping simulates smoking by creating an aerosol that contains nicotine but no tobacco. It does not contain the harmful tar associated with cigarettes, but does contain other chemicals. 
• Tobacco heated products. A tobacco stick that is inserted into a heating device, which brings the temperature of the stick to just below burning point. These deliver more than 80% of the nicotine of a cigarette while reducing levels of toxicants by almost two thirds, and particulate matter by at least three quarters. 
• Modern oral. A small pouch filled with nicotine, water and flavourings (no tobacco), which is placed between the upper lip and gum, where the nicotine and flavours are released over 20-30 minutes. 

BAT reported group revenue growth of 4.4% over the first half of 2023. Traditional combustible revenue was up 1.8%, while revenue from next-generation products was up 29%. Next-generation products now make up 12% of group sales, and this will become a bigger part of the mix. Whereas combustible volumes are decreasing, the next-generation product category is drawing in new users, through existing combustible smokers switching to next-generation products as well as consumers who are new to the nicotine category as a whole. 

BAT has positioned itself well in the vaping market, with a market share globally and in the US of 36% and 47% respectively. Vaping is clearly a growing business. Given that existing combustible products are high margin, the question is whether the growth in next-generation products will be margin accretive or dilutive. 

Next-generation products are at, or trending towards, combustible gross margins. The dynamic in the trending margins for e-cigarettes is that you either get a refillable or a disposable product. For the refillable pods or cartridges you first buy the e-cigarette device as a one-off (which is low margin and often subsidised), and then continuously refill the device with nicotine liquid, which is higher margin. Thus we expect vaping margins to increase further. 

On an operating margin basis a significant amount of research & development has been put into next-generation products, which gets deducted from gross profit. This has resulted in BAT’s next-generation product portfolio being loss-making at an operating profit level, to the amount of £1bn in 2020. Even so, BAT is expected to generate free cash flow of £8bn over its entire portfolio (combustibles plus next-generation products) for financial 2023. We see sufficient runway for combustibles before the next-generation product portfolio takes the lead in growing cash flow for the group. 

Regulatory risks mean combustible volumes will continue to decline, albeit with better pricing to offset this in the short to medium term. The FDA will move against flavours such as menthol, in both cigarettes and e-cigarettes. This is important for BAT because 25% of group profits come from menthol in the US. In December California banned menthol cigarettes and menthol flavoured e-cigarettes outright. Yet BAT managed to retain 90% of sales through menthol users switching to normal flavoured cigarettes and e-cigarettes, as well as some consumers buying menthol from neighbouring states. 

BAT trades on a rolling forward price/earnings and enterprise value/ebitda (earnings before interest, taxes, depreciation and amortisation) of 6.7 times and 6.9 times respectively, and a dividend yield of 9.4%, with annualised earnings expected to grow in the mid to high single digits over the next three or more years. Taking the worst-case scenario and assuming every US state bans every menthol product, and that every menthol user quits nicotine completely (combustible and vaping), then BAT will trade on a still reasonable 8.9 times PE and 7.1% dividend yield, assuming the share price stays constant.

BAT is moving away from being a tobacco company to more of a nicotine company. The transformation to a less harmful product portfolio that has a longer growth runway should lead to a less regulated sector in time — and it will still be a moneymaking machine.

• Short is a senior equity analyst in the Flagship global team with specialist macroeconomic expertise.