British American Tobacco: Navigating a Complex Transition That Warrants a High Fair Value

Management Summary / Key Takeaways

 British American Tobacco (BAT) is undergoing a strategic transformation that warrants a more optimistic forward-looking analysis than many observers currently provide. Key features of BAT's complex transition include:

1. Dual focus on diversification and careful claims management, balancing the shift away from traditional tobacco while managing legal challenges.
2. Strategic affiliates in emerging markets (Bangladesh, Malaysia, Kenya, Zambia) with minority shares listed locally, fostering financial sector development.
3. Significant 20% stake in ITC (India), a successful transition case and a "gemstone" asset on BAT's balance sheet. UPDATE NOV 7: Oct 23 BAT announced that it intends to sell what will be a 15+ percent stake in ITC's hotel business that will be spun off. We support this decision (for more info, see also the main body of the text in the paragraph about ITC). We will - for now - refrain from updating our estimates and assumptions. As soon as we will know at what price (and other conditions, if applicable) BAT will be able to see the stake in the hotel business in India, we will reconsider this.
4. Gradual reduction of tobacco association in growth markets like India, benefiting from share price appreciation while distancing from tobacco's negative image.
5. Leveraging century-long presence in emerging markets to build networks and relationships beyond tobacco.
6. Potential for higher growth rates and lower risk through strategic transitions and financial activities.
7. Management quality honed by industry challenges, positioning BAT for smart diversification into sectors where they have expertise and competitive advantage.

This multifaceted approach suggests that BAT's fair value may be higher than commonly perceived, as the company navigates its complex transition towards a more diversified, future-oriented business model.

Introduction 

British American Tobacco (BAT), headquartered in London, is in the midst of a complex and strategic transformation. While the company is gradually shifting from a traditional tobacco focus to a more diversified consumer goods entity, this transition is unfolding step-by-step, influenced by various internal and external factors, and often hidden by the size of the giant tobacco company.

 We believe that the strategy chosen is a smart one, albeit that at first case it seems strange that a company that is so much under attack (by health organizations, governments and individual consumers with claims who suggest that they are victims who did not know) doesn’t shout out loud what it is doing. We hope that our little narrative gives you food for thought.

Simply Wall Street's Fair Value estimate seems far off and extreme to many, who point to the situation the tobacco producers find themselves in in Western countries. But underneath the company is undergoing an amazing transition that warrants a somewhat more positivist forward-looking analysis.

The Dual Focus: Transition and Claims Management

BAT's journey is not just about diversification away from a main activity that is under siege because of health-related issues, fines, taxation etc in Western countries. But it is also about managing its substantial "claim" business. The company faces numerous legal challenges and financial penalties related to the health issues caused by tobacco use. This necessitates a robust legal and financial apparatus to manage legal claims and create tax-deductible provisions. These provisions, while suppressing immediate financial results, are crucial for long-term stability. And whenever there are years in which the budgeted penalties plus indirect claim-related cost of this non-core business, there is an extraordinary profit. Which then in turn can be paid out to shareholders, because the investment in the core business is not of the same level anymore as it used to be. Actually, to a certain extent you could already cynically ask the question: what is BAT’s core business? Tobacco or this financial and legal ‘claim’-related activity?

But there is more….

Strategic Affiliates and Emerging Market Focus

Tobacco cultivation is mainly done in former colonies, i.e. emerging markets countries. Meaning that the history of BAT in these countries goes back not 10 or 20 years, or at best 30-40 like for most entrepreneurs who do want to ride the waves of Emerging Markets excess growth rates these days. Nope. We are talking about a presence of more than 100-150 to sometimes even 200 or more years here!

And strangely enough, that incredibly long experience in those nations gives the company a big plus in that they have been able to create a network of relationships via this local presence. ITC, the Indian big consumption products company that in-and-of-itself is a very interesting asset of BAT via its 20 percent holding of ITC shares (see also ITC in the Simply Wall Street database!) is a good example. Started as IMPERIAL Tobacco Company it transitioned into INDIAN Tobacco Company and now ITC (abbreviation-only) as symbolic indication of the broader transition that BAT is going through. Later more about this when we focus on the – according to us – hidden BAT gemstones in BAT's balance sheet in general, and on its stake in ITC in India more in particular.

BAT's majority-owned affiliates in Bangladesh (73%), Malaysia (50%), Kenya (60%), and Zambia (75%) – with each of them already having the minority shares listed on local stock markets (see also their listing in Simply Wall Street) - illustrate its strategic focus on emerging markets. And if you like it or not: even with them still focusing primarily on tobacco-related business, the floating of the shares on local exchanges is good news for the development of the financial sector in those countries.

In a way a kind of ‘aid’ that helps with the development of the exchange as key element in a country’s growth from former colony into independent, diversified country. It is therefore not easy for Western nations to tell those countries that BAT is not a good party to collaborate with. Actually, don’t forget that the ones telling you this now as government and regulators in such countries are those that in the past – when your country was not free – where exporting ‘your’ tobacco to their country basically for free or far below cost.

These regions offer growth potential, yet the transition is still in its early stages. BAT is carefully managing its reputation and relationships in these markets, preparing for a future where tobacco becomes less central. With their collaboration with the financial sector in those countries getting more important. So basically, the tobacco giant is creating a network of local listings via which it can then step by step either: 1) transition the business and gain excitement for what is then less and less a tobacco-focused business model; or 2) float and sell shares at a good profit, which basically extends the ‘financial’ core activity of the firm beyond the one that was already started via the ’claim’-related business component.

Either way, these activities are from the perspective of the firm projects with higher growth rate and lower discount rate/risk than their beleaguered tobacco-only business model.

Investment in ITC and Indian Market Success

In India, where BAT holds – as indicated above - a 20% stake in ITC, the company has successfully begun its transition (note: in case you are able to directly buy into this Indian stock, it is most certainly of interest too!). The Indian market represents significant growth potential, and BAT's strategy involves gradually reducing its tobacco association by selling shares and retaining minority stakes.

This approach allows BAT to benefit from share price appreciation while distancing itself from tobacco's negative image. ITC is a great growth company, and the value of BAT’s 20% stake makes it one of the gemstone assets on the BAT balance sheet. Moving forward we can expect its relative importance to go up tremendously. But we often bump into financial analyses and valuations that fail to keep this transition in mind.

Emerging Markets grow faster than Developed Markets. And most certainly they grow faster than the Tobacco activities of a Developed Market-based global company that is under attack. Too often, analyses assume that BAT – as part of the so-called ‘seven dwarfs’ (the Big Tobacco giants) – is just going for defense, trying to continue to do what they do via circumvention of the law. But its management is not stupid. If anything, this is a company with incredible quality of management.

Being under attack in this sector all the time does also ensure that the surviving companies excel management-wise. It would be silly to assume that they are not smart enough to go for a transition into other activities/sectors for which they do have added value, expertise, experience and one or the other alternative quality that would give the firm once again good competitive position. But now via an activity that is not under siege!

This transition has already been started. In our opinion this warrants the incorporation of gradually growing expected growth rates of revenues and profitability on the one hand, and a relatively low discount rate on the other (albeit that we believe that the rate applied in the FV calculation of Simply Wall Street was on the low side; notwithstanding the fact that we do end up at relatively similar estimates; see also below).

What makes things complicated is of course that in Emerging Markets excess growth comes with excess volatility. A food company in Zambia or Kenya or India has higher fluctuations of financial value indicators than one in the US or EU. All other factors being equal.

See for instance, how the last 5 years were a period in which the still higher economic growth rates of companies in Emerging Markets did not align 1-on-1 with the movement of the relevant MSCI indices. The MSCI World (Developed Countries) outperformed the MSCI Emerging and Frontier Markets for most of this recent period.

However, we still see that the most amazing performances were in Emerging Markets, with for instant currently the Indian stock market as interesting example. India is the new China, but whereas China had – via Hong Kong – a gateway stock exchange via which foreigners could at least to some extent easily participate in this growth, India doesn’t have that. Instead, the financial regulators and government in the country has made it relatively hard for foreigners to invest locally. With the exception of the possibilities for Non-Resident Indians.

For many of you outside of India, BAT could be a neatly diversified point of entry to the Emerging Markets consumption sector. And that at a time when the Rise of the Middle Classes in these countries is ensuring them of interesting growth of the market for good quality consumption goods. In the meantime their high dividend yield and existing tobacco business work as a downside risk modifier.

 UPDATE NOV 7 - Demerger / IPO of ITC's hotel activities in India

Oct 23 BAT announced that it intends to sell what will be a 15+ percent stake in ITC's hotel business that will be spun off. We support this decision (for more info, see also the main body of the text in the paragraph about ITC). We will - for now - refrain from updating our estimates and assumptions. As soon as we will know at what price (and other conditions, if applicable) BAT will be able to see the stake in the hotel business in India, we will reconsider this.

We believe that the decision is good. ITC is the most important asset of BAT. BAT's CEO points out in the Oct 23 press release, that most analysts and others underestimate the complications of having a relatively large position in a company whose origins go back to the days of the British colonial occupation of India. With India now being one of the most attractive growth economies in the world, a decision to sell of stakes in a diversifying tobacco business now may easily translate into it being harder to re-enter later. That being said, we believe that it is also not good to let a valuable single asset dominate a diversified activity portfolio of a company that is under siege in Western nations, because its main product is considered a demerit good. So, basically, the demerger of the hotel business by ITC is a welcomed opportunity for BAT to cash in on some of the profits on their ITC stake without having to sell of exactly that part of it, that is most closely associated with BAT's broader industrial background: consumption goods.

Portfolio-wise, the incoming cash can then be used otherwise, when trying to strengthen BAT's balance sheet. When reading between the lines of the press release, we do not believe that this is going to be via a re-investing in ITC itself. With its currency controls, India is also not an easy country to withdraw large amounts of money from. Add to that, that BAT seems also convinced of the economic potential of the country, some subtle financial engineering may be required. We have confidence in the firm's capabilities in this respect.

For now, we will leave our estimates untouched, and will - if needed - change our assumptions, as soon as the IPO of the hotel business takes place, and/or when BAT will provide us with updated information on this case.

Dividend Strategy and Financial Resilience

But those of you who are following an investment strategy that is not in any way hindering them from investing in BAT because of ESG-related factors, can also be simply interested because of its dividend policy. Despite the various challenges mentioned above, BAT maintains a strong dividend yield, often above 5-6% (even 8.7% at the moment of writing!). This is often supported by the strategic release of extraordinary profits when claim provisions exceed actual costs. The company's ability to sustain high dividend yields reflects its financial resilience and strategic foresight. So, at first glance it seems unlikely that with existing profit levels the high dividend yields – paid out in 3-4 payments a year normally – are sustainable. But when you keep in mind that free-fall of provisions and a step-by-step reduction of reinvestment in tobacco translate into potential cash flow that is not directly aligned with annual profitability figures, you can understand why the high dividend policy is far more sustainable than the first glance analyses seem to indicate!

When looking at the Simply Wall Street snowflake that links its Dividend Policy to its Value Proposition, Future Prospects, Past Track Record and Financial Health you will actually see that this is most certainly also still a firm with quite a bit of financial resilience. So they do have the resources and time to work on their transition.

A Step-by-Step Transition

BAT's transition is according to us deliberately paced to ensure positive relationships with host countries and to optimize the monetization of its consumer goods investments. The company plans to gradually bring shares to market through IPOs or seasoned equity offerings, allowing for controlled growth and reduced risk. It would be not in the firm’s interest to make too much noise too soon. In the meantime the company can – on behalf of their affiliates – play the role of strong enemy for any local Emerging Markets government that tries to piggy back Western governments, regulators and private lobby groups. I.e. introduce a new policy of attacking and penalizing the firm 'for the quick buck'. The risk of an interesting firm that has done so much to transition into local partner then leaving the country or at least use its financial resources against you, is too big. And not just that: in the meantime most Emerging Markets are not faced with populations that turn anti-smoking at the pace that we see in the West. So the existing tobacco biz is more profitable still and revenues are not as much under pressure yet.

The advantage of stepwise transition below the surface is also that it gives BAT the time to work on the transition with as large as possible a percentage holding in the firms, now that the most likely development of the underlying share values in these companies is going up. With the pace of increase in the nearest future smaller than later. So BAT is not in a hurry. The ITC case is a good example. The longer you wait, and the slower you act, the larger the value that you generate. Compare the case of Big Tech companies in the US. Most of the giants and other successful companies that went way further than unicorn status were those where the founders kept a relatively larger stake for a longer period of time. I.e. they did not sell out to Private Equity or Venture Capital too quickly. And neither did they sell record amounts of what they owned at the time of an IPO, or even during later seasoned offerings. In a way Jensen Huang at Nvidia, Mark Zuckerberg at Meta, Jezz Bezos at Amazon etc understand this part of the BAT story well. And vice versa.

Of course: investors are always impatient. Preferring the shorter term growth and profits over things that are further away in the future. We feel that the management of the ‘seven dwarfs’ in general and BAT in particular have shown their stamina, backbone and discipline to an incredible extent. We are confident that they won’t rush or panic with one or a few disappointments.

Actually: for investors who like the Emerging Markets Growth story but feel a bit unsure about their own skills to wither the storms in those volatile markets, this tobacco giant may make for a credible partner in this effort. Not the one you think of immediately when asking about Emerging Markets equities at your bank, but one that is not necessarily selling you a simple ETF ran buy 25-35 year old portfolio managers from their desks in London, New York or Singapore, but instead one in which they are your ‘local’ local partner who is home in many Emerging and Frontier Markets countries for many decades if not centuries.

 Long-Term Vision: From Tobacco to Consumer Goods

Summarizing things: Over time, BAT aims to transition from a tobacco-centric company to an emerging market-focused consumer goods investment company.

This journey, while fraught with short-term risks and public scrutiny, promises long-term benefits. As BAT diversifies its business, it anticipates lower risk levels, aligning with the consumer goods sector's more favorable perception. That will have a positive impact on valuation levels.

We believe that it is warranted to run a version of the Simply Wall Street Fair Value calculator in which we incorporate this strategic analysis in figures that will show elements of this in the figures and assumptions that we use.

A Modified Fair Value Analysis for a Transitioning Hidden Consumer Goods Giant

Today’s fair value (we write this narrative on Sep 23, 2024) is according to the Simply Wall Street analysis GBP 67.98. At a time when the stock price is GBP 28.10. Over the last 12m the maximum price was GBP 29.84. When we extend our interval to 3 years, the maximum was GBP 36.28 and the minimum remains GBP 22.67, a value that was reached during the last 12 months. These numbers also remain the min and max when we extend our time interval to 5 years. However, when using the maximum time interval option in Simply Wall Street we reach a maximum high of GBP 55.80 and a minimum of GBP 2.35 (!).

Stated differently: current valuation levels are neither very high – and that was to be expected of a company whose old business model is under siege – but also not extremely low. We believe that this is a different way of saying that management has been capable of withering quite a few storms already, thereby confirming what we said earlier about their management qualities in what is not an easy situation.

But the Fair Value estimate of GBP 67.98 seems way off. Or not? Our analysis below shows that this is not an outrageous, overly optimistic number. However, we reach it in a somewhat different manner.

Assumptions

REVENUES

The revenue growth rate used in Simply Wall Street is currently 1.95% per annum. Much higher than the 0 / declining rate of the tobacco industry in the Western world. It is therefore already more in line with the ‘normal’ growth rate of revenues for companies with a point of gravity in Emerging Countries albeit that it is still on the low side. Also taking into account that we believe that the company has reasons to not hurry into things, we will adjust the growth rate upward. But not by a landslide. We will put it at 7%.

With the caveat that we expect it to grow way faster in the more distant future, but for now this higher rate is in line with the transition that the firm goes through. It is not impossible that – with India as jewel in the crown via ITC (and as example for other affiliates – double-digit revenue growth and a profit margin higher than the 20% we use (see below under PROFIT MARGIN) are not impossible.

PROFIT MARGIN

Currently, the firm has a temporary negative profit margin of -53.0% versus a profit margin of 16.4% for the tobacco industry. Simply Wall Street calculated with the latter rate. We believe that a transition towards more diversified consumption goods away from tobacco, will – also taking into account a shifting point of gravity from Developed to Emerging nations enable the company to step up the profit margin target to a realizable 20%.

 PRICE EARNINGS RATIO

Today’s PE is a negative -4.47x because of the more or less ‘coincidental’ loss situation. The forward looking PE in Simply Wall Street is positive  around 9x and the tobacco industry is at 10.79x. But the transition towards more Emerging Markets but also more Consumer Goods (general) as opposed to Tobacco will have two effects.

Emerging Markets companies have lower PE’s than Western companies. And with the visible presence in Emerging countries going up this is a negative for the PE estimate. On the other hand, there is the positive of Consumer Goods companies having PE’s that are more in the 20+ zone than that of Tobacco and Emerging Markets companies in the 5-10 zone. Since we believe that the transition will – especially in the earlier years – translate to a growing number of positive earnings surprises, because ‘rearview mirror’ type of analyses are being replaced with growing numbers of analysts and investors learning about the transition, we believe that the use of a 20x PE ratio is warranted.

DISCOUNT RATE

The discount rate used in SWS is currently 6.87%. We consider this way too low. Tobacco is risky business. And so is going deeper into Emerging Markets. The uncertainty of the claim-related business (results of past years do not necessarily mean much in the years ahead of us; every year starts from scratch with the only certainty being that the anti-tobacco lobby is gaining momentum in ever more countries) and of Emerging Markets in general demands an above average discount rate. Using a long-term discount rate of 10% we derive a Fair Value Estimate that is lower than the GBP 67.98 shown in Simply Wall Street. Ours is GBP 43.31 when looking 5 years into the future.

The list below gives our estimates 3, 5 and 10 years into the future using the Simply Wall Street Fair Value estimator:

• Three Years Into The Future : GPB 45.77
• Five Years Into The Future GPB 43.31
• Ten Years Into The Future GPB 37.22

FV estimates using different future time intervals using a 7 percent per annum expected revenue growth rate.

The fact that there is a downward trend when expanding our horizon, is directly related to the fact that our use of a higher discount rate than in the SWS calculations pressurizes the firm to ‘deliver’ and get to proper double digit growth rates when they transition more and more from tobacco firm into consumption sector entity in Emerging Countries. We are confident that this is possible.

For that purpose we have added the same calculation but now with an expected growth rate of double the percentage used (i.e. 14 percent as opposed to 7). That is more in line already with a successful transition into broad-based consumption goods company.

• Three Years Into The Future GPB 55.36
• Five Years Into The Future GPB 59.46
• Ten Years Into The Future GPB 71.08

FV estimates using different future time intervals using a 14 percent per annum expected revenue growth rate.

We believe that our ‘realistic and forward-looking’ calculation may provide skeptical investors with a somewhat less exuberant but easier to understand and/or believe fair value picture. One that will not in the shortest term (horizons of 1-2 years) translate into share prices that return fully to the historical max of GBP 55.80, but that will go quite a bit up from where we currently are. And we should not be flabbergasted when positive earnings surprises start to pop up during the next 3-5 years in case of for instance very good growth in India.

And that is why we believe that BAT is not a stock to ignore, but an interesting LT story for those investors who like Emerging Markets growth but don’t fully trust themselves there. Or simply for those who don't have the means to expand their portfolios easily into these higher-growth markets.

Conclusion: A Complex but Promising Path

British American Tobacco's transformation is a complex, multi-phase process that requires careful management and strategic foresight. While the company faces short-term challenges, its long-term vision offers the potential for extraordinary profits and reduced risks. Investors can appreciate the journey by enjoying attractive dividend yields and observing the company's evolution over time.

NOTE:

We have a position in the stock, initially for dividend purposes but more and more because our digging deeper unraveled the transition that is under way. Via the dividend yield and the emerging markets (and especially India via ITC) exposure to BAT is for us more than just an anti-cyclical, deep-value investment in a (tobacco) company of the past.

ABOUT ME:

I am Erik L van Dijk (http://www.linkedin.com/in/evd101), 62 years old and a former CEO/CIO in institutional asset management who retired from managing money for others. Instead, I focus solely on my own family office now. I started my career as professor of finance in Amsterdam, specializing in quantitative models for equity investing; with a focus on Emerging Markets. I turned professional investor after my startup company – via which I sold financial model output and data to interested qualifying investors – was acquired by a Dutch insurance company. Over the years my academic interests have remained. Also when already active as professional investors.

I am currently based in the UAE, focusing on my own investments. After my retirement from institutional money management for others about 5 years ago, I am not in any way associated with asset management firms or other financial institutions.

On the side, I am ambassador for a local free trade zone in Dubai, and mentor for startup companies. This narrative is not meant to be a buy, sell or hold recommendation. All we intend to do here is to share our line of reasoning, so that other investors can use or modify it for their own due diligence processes. We also believe that they may have educational added value for DIY investors, because we will focus on relatively complicated investment cases for which not-that-much information is available. Research and due diligence results presented are all ours and original content.

Our investment theses for the LT portfolio – from which we derive these narratives – are truly multiple-years focused. We run separate short-term trading portfolios in which we use substantial leverage, but the narratives presented here are from our non-leveraged, LT analyses. We may present cases of companies that we have a stake in, or companies where we don’t have a stake. In all cases: we are independent of the firms we invest in. And we do not receive any kickbacks. All we do here is to share information that we generated as part of our own due diligence processes.

As far as LT holding periods is concerned. We expect to stay with firms for periods of 3-5 years. However, we do apply a stop loss of 50% and a take profit of 75%. Earlier profit taking is therefore possible. To the extent that we continue to believe in the thesis – which will be regularly updated – we are allowed to use bad periods to reduce the average acquisition price by buying more of a stock. In similar fashion, we are also allowed to re-open investment cases after a Take Profit has been hit. We do not consider a renewed investment to be a continuation of the existing case, but a new case based on the same underlying company.