British American Tobacco goes smokeless – can it survive?

If financial markets were efficient, then shares would not trade below their intrinsic worth and value investing would not exist. Similarly, if human beings were rational, then they would not smoke cigarettes. We have known for decades that markets are not as efficient as economists’ theories pretend, while there is a link between smoking and serious health problems. Yet undervalued shares and tobacco companies do exist.

Shares in British American Tobacco (LSE: BATS) are trading on seven times next year’s forecast earnings and offer a dividend yield of just over 9%; the company aims to buy back £700 million of shares in 2024, rising to £900 million in 2025. These numbers suggest that BATS has all the features of a traditional “value stock”.

Aside from appealing to value investors, tobacco companies are also rehabilitating themselves with less harmful products. The company publishes an “ESG roadmap”, alongside targets for climate change, biodiversity, women in leadership roles and ethics. BATS’ management is committed to building a “smokeless” world.

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They target smokeless categories to exceed 50% of revenue by 2035, compared with 18% of group revenue now. That seems ambitious, but the company has fallen behind NYSE-listed Philip Morris International (PMI), which sells Marlboro cigarettes, but also IQOS vapes. In the quarter to 30 June, PMI reported 38% of revenues from smoke-free products and aims to increase that to two-thirds of sales by 2030.

The investment story that management would like to tell is one of declining cigarette sales offset by growth in lower-risk smokeless products. BATS is certainly seeing an accelerating decline in cigarette sales, down almost 14% in the first half of the year; yet the group warned in July that its smokeless products may also miss next year’s targets.

Consumers have switched from cigarettes to buying unauthorised single-use vapes such as Elfbar (recently rebranded EBDesign), imported from China. For that reason, the legal vapour market, including BATS’ Vuse brand, is in decline. BATS is optimistic that the US authorities will soon crack down on the sale of unauthorised vapes. Until then they estimate that those vapes represent over 60% of the total US vaping market, which translates to £60 billion of revenue in the US alone that could be up for grabs.

However, declining cigarette sales and revenue growth down 8% in the first half are not the only reasons that the group trades at a low valuation. In 2017, BATS bought the 58% of Reynolds American that it did not already own for $49 billion. It had been a 42% shareholder in Reynolds since 2004. Aside from geographic expansion, a rationale for the deal in 2017 was “next-generation products”. BATS had already launched glo, a heated tobacco product in Japan, with encouraging results; but Reynolds had owned Vuse, one of the leading US vaping brands, which now has a global market share of just over 40%.

The Reynolds deal stretched BATS’ balance sheet, resulting in £124 billion of intangible assets, funded by borrowings of almost £50 billion and shareholders’ equity of £66 billion at the end of 2018. Management continues to pay down the debt, expecting net debt/ earnings before interest, taxes, depreciation and amortisation (EBITDA) to fall below 2.5 times by the end of 2024.

Then, in October 2023, the FDA issued a ban on Vuse’s menthol-flavoured vapes. Menthol represents around three-quarters of Vuse’s sales. A couple of months later, BATS announced a non-cash impairment charge, subsequently writing down the value of the acquired US cigarette brands by £28 billion, in February this year. This meant BATS reported a statutory loss of £15.8 billion in 2023, the second-largest loss for a FTSE 100 company (NatWest’s £24 billion loss in 2009 was the largest).

The dividend yield of over 9% is 1.5x covered. The challenging revenue environment is now recognised and the shares have risen 10% since 1 July. A Capital Markets Day themed around the firm’s “sustainable growth algorithm” happened on 16 October at the company’s innovation centre in Southampton. Such language borrows from cash-rich, high-growth technology companies, though there’s little in BATS’ numbers to suggest such a parallel with large-cap Nasdaq-listed stocks is valid. That said, if management can show improving prospects for their smokeless products, it could be enough to light up a return to intrinsic value.

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