British American Tobacco (BAT), often referred to as BTI on the NYSE, offers a unique investment opportunity. At just under $32.5 per share, BAT boasts an attractive forward Price-to-Earnings (P/E) ratio of approximately 7 and a generous dividend yield of 8.6%. In this article, I'll delve into why I consider BAT to possess a robust competitive advantage in the tobacco industry, making it an enticing investment prospect.

Understanding BAT's Diverse Portfolio

British American Tobacco's product portfolio comprises three main categories: combustibles, traditional oral products, and new categories, collectively known as Next-Generation Products (NGPs). While combustibles currently drive the bulk of their revenue, NGPs are poised to shape the industry's future growth, compensating for the decline in traditional tobacco sales. Let's explore these categories to gain insight into BAT's business outlook.

Combustibles: The Profitable Foundation

Combustibles include tobacco products that burn, with cigarettes being the primary offering. This segment, historically dominated by a select few industry giants, presents formidable entry barriers. These barriers encompass brand recognition, product addiction, economies of scale, regulatory expertise, and expansive global distribution networks. Consequently, these companies enjoy remarkably high operating margins, exemplified by BAT's 40% operating margin, surpassing even tech giant Apple's consistent 30% margin.

However, combustibles face formidable challenges. Stringent global regulations on tobacco advertising, packaging, and public smoking aim to reduce harm and protect public health. Such bans deter new competitors and hinder existing firms from attracting fresh customers. Additionally, hefty taxes in most countries deter usage. The global smoking population has dwindled, particularly in the US, signaling a broader trend within the industry. The sustainability of BAT's combustibles profits is thus a pertinent question.

To counter declining smoking rates, BAT and peers have employed a strategy of raising prices. Although cigarette volumes have plummeted in the US, price hikes have effectively mitigated revenue loss, a testament to BAT's pricing power. With a US average cigarette price of $9 per pack, well below prices in countries with comparable GDP per capita, there remains significant room for further price increases.

Traditional Oral Tobacco: A Fading Segment

Traditional oral tobacco, contributing 4% of BAT's revenue, faces a trajectory similar to combustibles, gradually giving way to less harmful modern oral products.

New Categories (NGPs): The Future of Tobacco

Next-Generation Products (NGPs) encompass various non-combustible tobacco and nicotine products, including e-cigarettes, heated tobacco, and modern oral offerings. NGPs are perceived as lower-risk alternatives to traditional cigarettes, avoiding the harmful byproducts of combustion. BAT leads the e-cigarette market globally and ranks second in both heated tobacco and modern oral products.

E-cigarettes, also known as vapor devices, heat a liquid to produce inhalable aerosols. BAT's Vuse brand claims the top spot globally, boasting a 35.9% revenue share, including dominance in the US market.

Heated tobacco products (THPs) represent a novel approach, heating tobacco instead of burning it. While BAT's brand, glo, trails Philip Morris, the heated tobacco market in the US remains small, but this is set to change in 2024 when Philip Morris enters the US market. BAT's decision not to rush its glo product into the US market raises questions, considering the US's significant revenue potential.

Modern oral products, like nicotine pouches, cater to smoke-free, oral nicotine consumption. BAT's Velo brand leads in Europe but lags in the US.

In 2022, NGPs constituted 17% of the tobacco industry, projected to drive the majority of future growth. E-cigarettes and heated tobacco each account for nearly half of this share. These segments are expected to fuel the industry's growth, even as traditional tobacco and oral products experience declining volumes.

Assessing Profitability in NGPs

Predicting NGP profitability can be challenging. BAT's CFO noted higher profit margins for tobacco heating and modern oral products compared to combustibles, while e-cigarettes boasted a 50% margin, albeit lower than combustibles. E-cigarette manufacturers can employ synthetic nicotine, bypassing the need for a tobacco leaf supply chain. Startups like Elf Bar have capitalized on this advantage, swiftly gaining market share. However, intense competition in this space may squeeze margins.

In contrast, heated tobacco products, reliant on actual tobacco leaves, remain less fragmented and dominated by established players. This is a domain where multinational tobacco companies excel, and new entrants are unlikely.

Valuation and Investment Thesis

BAT, while trailing Philip Morris in NGP market share, outperforms other major tobacco companies. The investment thesis for BAT rests on its significant undervaluation, driven by its competitive moat within the tobacco industry. The revenue generated by NGPs is poised to offset declining traditional cigarette sales.

Comparing BAT to companies like Procter & Gamble (PG) and Coca-Cola (KO), which have experienced stagnant revenues, BAT's current P/E ratio of 7 stands in stark contrast to their P/E ratios of 25. Closing this gap even partially, with a P/E of 10 and 2023 consensus per share earnings of £3.79/$4.82, could result in a share price of $48.2, a 50% increase. Meanwhile, investors would enjoy an 8.7% annual dividend yield while awaiting price appreciation.

Furthermore, BAT's 28% stake in ITC Ltd, valued at around $18 billion, adds significant value to its market capitalization.

Comparing BAT to peers, Altria and Philip Morris, reveals intriguing disparities in valuation. Despite its strong position in NGPs, BAT's exposure to the US market is just 50%, while Altria, focused solely on the US, trades at a higher valuation. This divergence raises questions about market perceptions.

Acknowledging Risks

Several risks merit consideration. Firstly, the FDA plans to ban menthol cigarettes in the US in 2024, impacting a significant portion of cigarette sales. Secondly, BAT's financial leverage, stemming from its 2017 acquisition of Reynolds American, although manageable, remains a concern. Lastly, the unexpected CEO change raises questions about the company's underlying dynamics.

In Conclusion

In summary, BAT's potential risks do not significantly alter the investment thesis. The main uncertainty lies in NGPs, particularly heated tobacco, where BAT strives to catch up with Philip Morris. BAT's deep understanding of consumer behavior, competition, and regulation forms its core competitive advantage, which has historically propelled its success. I am confident this track record will continue, British American Tobacco presents a compelling opportunity, backed by its competitive moat and the promising growth prospects of NGPs, making it a noteworthy addition to any investment portfolio.