British American Tobacco: Consensus Bulls May Be Wrong Again

Performance Review

I had a "Strong Sell" on British American Tobacco (NYSE:BTI) (OTCPK:BTAFF) in my last article on this stock. Out of the last 41 Seeking Alpha articles on this company, I have been the only bear on the stock, compared to 20 "Strong Buys", 17 "Buys" and 3 "Holds". Wall St has also rated the stock bullish over the last 90 days:

My stance has not only been very contrarian, but also rather controversial, as evidenced by the very lively comments discussion in my prior article. Luckily, sticking my neck out against the consensus has worked out as the market has so far ruled in my favor:

Since publication of my last article, BTI has delivered a total shareholder return of -0.89% compared to the S&P500 (SPY) (SPX) (VOO)'s return of +8.59%. This corresponds to an alpha/outperformance of +9.48%.

The consensus bullish argument for BTI has been based upon low valuations and 'progress' on new growth products on the non-combustibles side. However, I do not see a compelling case for these arguments:

Thesis Update

After reviewing H1 FY23's results, my bearish thesis remains intact for the following reasons:

1. Combustibles still matter most; don't let narratives outweigh the numbers
2. New categories do not move the needle
3. Secular decline may be stronger than it seems
4. The stock continues to be a value trap

Combustibles still matter most; don't let narratives outweigh the numbers

BTI reports a lot of granular data along with extensive commentary. In H1 FY23, we also saw some key events involving a CEO change following an earlier misconduct. However I think a lot of this is noise that does not matter. The stock's performance is still driven heavily by the Combustibles business' performance, which makes up almost 82% of total revenues. Here's the product and geography split:

Adjusted refers to the stripping away of inorganic parts to capture organic growth. CC stands for constant currency. Organic CC growth is a better measure to assess performance as it focuses on the core business, excluding the impact of external forces outside management's control such as FX movements

From a P&L contribution perspective, the New Categories segment is still unprofitable as it posted a GBP -12mn loss in H1 FY23. Hence the weightage of Combustibles matters even more the lower down we go towards earnings and cash flows.

New categories do not move the needle

Some commenters in my last article pointed toward the growth in new categories as a reason to be bullish. This is certainly the narrative management tries to sell investors. However, even after accounting for its higher 14.6% YoY growth, the numbers prove that the impact is not large enough to really move the needle. To illustrate this, we can look at the weighted revenue contribution, which takes into account both the mix and the growth:

The non-combustibles contribution is still printing close to 2-3% here. Unless this materially accelerates, I believe the overall combustibles mix will continue to decline at a glacial pace of ~200bps every year:

Note again that this analysis looks even worse for the non-combustibles segment at an earnings or cash flow level since the segment is still unprofitable.

Secular decline may be stronger than it seems

BTI's Combustibles segment continues to be a declining business, particularly on the volumes front:

Management attributed 26% of the overall industry's volume decline in the US to secular declines and 37% to "Consumer macro impacts", which includes inflationary impacts:

And at the same time with massive inflationary pressures that put a lot of pressure in terms of consumer purchase power.

- CEO Tadeu Marroco in the H1 FY23 earnings call

However, I suspect there is a greater proportion of secular decline to the story here than temporal macro drivers. Some evidence to support this view comes in when we look at the inflation data reported by Trueflation, which is arguably a more real-time measure of the inflation rate in the US economy:

According to Trueflation, inflation has reduced or at best, remained stable in the US economy. The latest data print shows 2.37%.

The stock continues to be a value trap

As I had anticipated, BTI has de-rated from its previous 1-yr fwd PE of 8.90x at the time of my earlier publication to 6.65x today:

The discount to the longer term 1-yr fwd PE multiple of 12.32x now stands at 46.1%. This may attract the interest of many value investors. However, I believe considering the gearing of the business to the secularly declining combustibles market, the stock continues to remain a value trap. Observe how the stock has continued to de-rate from previous 'discount' levels; when it was at a 10.00x 1-yr fwd PE, it traded at a ~20% discount to the long-term average. In my view, this is a classic example of the need for a genuine operational catalyst to trigger prudent value buys.

Key Monitorable

It is difficult to turnaround a business that is in secular decline. I believe the stock would be headed toward a more optimistic direction if and when it starts to diversify into new segments, ideally not highly regulatory-constrained, as that would expose the stock to the same regulations factor risk (in other words, cannabis diversification won't cut it). The Indian cigarettes leader ITC is a strong example of successful business diversification.

Perhaps the new CEO Tadeu Marroco will steer BTI along this path. This is the key thesis-changing monitorable I would wait for. Besides this, there may be some small periods of BTI outperformance over the market. However, I anticipate these to be temporary. I will update you all on the tactical changes in my stance, either in another article or via a pinned comment to this piece.

Takeaway

With a 'Strong Sell Rating', I have been the only bear on British American Tobacco since November 2022, which has not only been a contrarian position but also a controversial one as it looks like the stock garners the favor of many investors on Seeking Alpha.

I gain confidence in the results; British American Tobacco has underperformed the S&P500 by +9.48% since my last publication, even posting a negative total shareholder return of -0.89%.

The H1 FY23 results have renewed confidence in my thesis; combustibles still matter the most and they continue to be in (probably understated) secular decline, non-combustibles are not growing fast enough to move the needle, and the stock continues to de-rate as expected, remaining a value trap.

Thus, I will stick my neck out again and continue rating the stock a "Strong Sell".

How to interpret Hunting Alpha's ratings:

Strong Buy: Expect the company to outperform the S&P500 on a total shareholder return basis, with higher than usual confidence

Buy: Expect the company to outperform the S&P500 on a total shareholder return basis

Neutral/hold: Expect the company to perform in-line with the S&P500 on a total shareholder return basis

Sell: Expect the company to underperform the S&P500 on a total shareholder return basis

Strong Sell: Expect the company to underperform the S&P500 on a total shareholder return basis, with higher than usual confidence

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.