British American Tobacco: A Weak Outlook

Thesis

I am bearish on British American Tobacco (NYSE:BTI) (OTCPK:BTAFF). Here's my 3-point thesis:

1. Combustibles matter most; don't let management distract you otherwise
2. Combustibles is seeing a broad-based volume and growth slowdown
3. Consumer sentiment indicates further weakness ahead

Combustibles matter most; don't let management distract you otherwise

BTI's earnings calls and investor presentations focus a lot on business transition and ESG. However, investors should let this distract them from what the hard numbers show:

CC stands for constant currency; this is a better measure to assess performance as it excludes the impact of external forces outside management's control such as FX movements

As of H2 FY22, 82.8% of the entire business still comes from combustibles, of which the majority consists of regular cigarettes. It is true that the company is reducing the mix of this segment, however progress has been at a glacial pace:

Over the last 3.5 years, the combustibles' adjusted CC revenue mix has fallen from 89.9% to 82.8%; a mere 706bps decline. Annualized, this is about a 177bps reduction in the combustibles mix every year. And the growth rate during this time has been a paltry 1.3% CAGR. This is below the 2018 - 2022 industry growth rate of 2.6%.

So BTI is stuck with an underperforming combustibles segment as the primary driver of the stock. The transition to newer categories is not happening fast enough.

Combustibles is seeing a broad-based volume and growth slowdown

The overall combustibles segment is de-growing at more than 7% YoY for 2 consecutive quarters now:

This de-growth is primarily due to an accelerating volume decline:

But also a marginal YoY fall in average selling prices:

This particular attribution for the overall de-growth in the combustibles business is not favorable since volume declines for an addictive product signify meaningful shifts in consumer behavior. It is also surprising that on an aggregate level, BTI has not been able to raise prices in 2022 despite worldwide high inflation during this period.

In the H2 FY22 earnings call, management highlighted a pivot toward value-focused selling strategies:

In the U.S., the market remains more at around 2.5% of total nicotine value and highly competitive. Revenue was up as we pivoted to drive value, reducing promotional support...

- Finance & Transformation Director Tadeu Marroco in the H2 FY22 earnings call, Author's bolded highlight

I believe this exposes BTI to even more intense competition since the value-segment is a prime target for the illegal tobacco trade, which has been gaining share globally.

The overall slowdown in the combustibles segment is broad-based across geographies:

This is mostly due to a steep drop in volumes in the developed markets of the US and Europe, which make up 35.2% and 19.6% of H2 FY22 combustibles revenues respectively:

In the H2 FY22 earnings call, management admitted a loss in market share as BTI's volumes fell 500bps more than that of the industry. Pricing pressures as the mix shifts toward value is also leading to a 500bps YoY hit on margins:

Overall, BTI is losing combustible tobacco product market share on both volume and value terms across almost all geographies, which is dragging the margin profile as well. I am skeptical of management's claim of resiliency as I anticipate an increase in competitive intensity as the strategy pivots to focus on 'value', thus taking the formidable illegal tobacco market head-on.

Consumer sentiment indicates further weakness ahead

In the H2 FY22 presentation, management highlighted consumer sentiment to be key macroeconomic indicators that affects BTI's business. A read of this indicators does not paint a rosy picture ahead:

The University of Michigan Consumer Expectations index saw a sharp 11.7% fall from 60.5 in April 2023 to 53.4 in May 2023's preliminary release. These figures make me believe combustible volume growth is likely to remain tepid for BTI.

Takeaway

British American Tobacco's combustibles business is the key driver of stock performance as it contributes almost 83% to the overall business' revenues. The transition toward 'cleaner' nicotine products is happening at a rather slow pace.

The combustibles segment has been facing volume pressures across most geographies, which is a worrying sign especially for an addictive product such as cigarettes and other traditional nicotine-based combustible tobacco forms. The average selling price of consumables has also seen a marginal decline as the company has shifted focus toward the value segment. This has led to a YoY 500bps hit on margins. I believe with the value-focused strategy, the loss in volume and value market shares is likely to continue as the company faces increased competitive intensity with the illegal segment of the tobacco market, which operates at lower price points.

Finally, consumer sentiment indicators saw a sharp fall in May 2023, which I think bodes poorly for British American Tobacco. I rate the stock a 'Strong Sell' as I anticipate a further de-rating from the current 1-yr forward PE multiple of 8.90.

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