British American Tobacco: Capital Markets Day Recap

seekingalpha2024-11-05

British American Tobacco showed promising new innovations in all three NGP categories on its recent Capital Markets Day.The two-piece Glo Hilo device seems to improve on current consumers' pain points...

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Solskin I've covered British American Tobacco (NYSE:BTI) not too long ago as my first article as an analyst here on Seeking Alpha. I came to the conclusion that BTI is undervalued, as the company is growing earnings while trading at less than 8x free cash flow. In that article, I also outlined that the company is making progress with its next-generation products (NGP), but to effectively compete against Philip Morris (PM) and smaller emerging companies in the newly evolving nicotine industry, they would need to step up their innovation. It seems like BTI has listened to my calls, as they've recently released great insights to their upcoming innovations, which we will cover in depth in this article. As the largest position in my concentrated portfolio, I follow British American Tobacco very closely. I had been waiting for the Capital Markets Day that took place in October to get some insights on where the company may be headed in the future. I understand that for most investors, BTI is just one stock among many, it's therefore hard to justify watching an almost 5-hour webcast that goes through hundreds of presentation slides. It's simply too time-consuming in our busy world, but luckily, you don't have to watch the whole Capital Markets Day because I'll provide you with a summary of the most important developments. A lot of what has been said can be dismissed. BTI showed many colorful pictures about how the company is changing culturally and how they're well-equipped to thrive in a future beyond cigarettes. While anyone watching BTI for a while might have recognized the changes the company went through over the last couple of years, we're only focusing on what really matters for shareholders. Before we get to the summary of the Capital Markets Day, let's see what challenges tobacco companies face these days. You could skip this section, and go straight to the Capital Markets Day recap, if you're only interested in this event. Tobacco Majors Are Facing Challenges Historically, the tobacco industry hasn't been known to be very innovative, and they didn't have to. Cigarettes have been shielded from competition for decades due to advertising bans and government regulations. The most remarkable invention tobacco companies came up was the introduction of cigarette filters in the 1950s, that's a long time ago. Times have changed since then, and they now operate in a technology-driven shift to smokeless devices. Just like the car industry is facing emerging electric vehicle companies, tobacco companies are threatened by hundreds of emerging Chinese companies like Elfbar fighting for their spot in the newly evolving nicotine industry. The days of slow innovation are over, and BTI has finally started to recognize that. While the company launched its first vapor products in 2013, it's only in recent years that they started to pick up some steam with their new generation products. It shows how difficult it is for large companies in a historically slow-moving industry to change and transform. BTI and other major tobacco companies have big advantages over car companies that face similar challenges, though:  Tobacco companies operate in a mostly recession-resistant industry compared to the cyclical automobile industry. Tobacco requires very little capex and is therefore highly cash generative, the automobile industry needs constant reinvestment. Due to tobacco's addictive nature and oligopolistic structure, the major companies have enormous pricing power. And therefore, tobacco stocks have been one of the best-performing sectors globally during the last 120 years, even though they're facing declining cigarette volumes in recent decades in the developed world.  Why this pricing power is so important has been once again demonstrated by Altria at its Q3 results presentation. Cigarette volumes have been down by 8.6% and profits are up. Investors cheered with an almost 8% rise in share price on a day when markets were down. Imagine any other business showing high-single digits volume declines, investors would run for the exits. As the biggest tobacco company measured by free cash flow, BTI enjoys similar pricing power in its combustible business, yet it trades at depressed valuations. Mr. Market is valuing the company at less than 8x free cash flow right now. In my opinion, even if BTI had no ambitions to compete in next-generation products (NGP), the combustible business alone would be worth that much, as pricing power should help keep cash flows stable for quite some time. But fortunately, BTI is striving for a future beyond cigarettes, and it seems to be stepping up its pace as shown on its recent Capital Markets Day event, which we'll cover soon. BTI's NGPs have recently become profitable after more than a decade of operating in this field. With 17.9% of their revenues coming from smokeless categories, it's far behind Philip Morris, which had 38% of their revenues coming outside of combustibles. However, BTI is ahead of Altria (MO), Imperial Brands (OTCQX:IMBBY) and Japan Tobacco, with the latter two having less than 4% of their revenues coming from NGPs. Although it's a distant second to Philip Morris when it comes to profitability, its chances for success are becoming increasingly likely, yet it's currently the lowest priced tobacco major when it comes to P/FCF. BTI is a hated stock in a hated sector, trading in an unloved country. As a contrarian, I like that. Capital Markets Day Recap British American Tobacco's recent Capital Markets Day started by highlighting that the nicotine industry is growing. While the company expects a further shift away from cigarettes to NGPs, revenues should be growing at 4.6% CAGR from 2024-2035. Nicotine Industry Is Growing (BTI Capital Markets Day Presentation)While I agree that revenues will be growing for the industry, part of the growth will be coming from smaller emerging Chinese companies, which are especially strong in the vaping category. Also, Philip Morris has been growing its revenues more quickly than BTI in recent years, benefiting most from this trend. Vaping In its presentation slides, BAT highlights that they're the global value share leader in vaping, with a market share of 40.4% YTD. Those numbers should be viewed with caution, as it only represents tracked channels like grocery stores and gas stations. Capital Markets Day Presentation Capital Markets Day PresentationVape stores, online shops and other popular places for buying vapes are not represented. In untracked channels, Chinese vapes are really popular and Vuse has less of a presence. Let's do some easy calculations to determine where BTI really stands in the vaping category right now. BTI had GBP 1.8 billion in vaping revenues last year, which equals roughly $2.3 billion. The vaping market has a size of $28 billion globally, therefore BTI is far from having a 40% market share. Elfbar seems to be the most popular vape right now, but in a fast-moving industry like vaping that can change quickly. Heated Tobacco The numbers for heated tobacco and nicotine pouches are more accurate. Heated tobacco is mostly shielded from competition outside of Big Tobacco, since it requires a wide distribution network and expertise in tobacco manufacturing. BTI has a roughly 17% market share in heated tobacco YTD. But as it only competes in the non-premium segment of the category and is heavily discounting the devices, it hasn't been profitable for them so far. In contrast, the market leader PM with a market share of 80% has higher profit margins for IQOS than cigarettes, mostly because of lower taxes. Nicotine Pouches Nicotine pouches haven't seen threatening competition from smaller players so far, although the competitive landscape could change in the future. The category is one of BTI's strengths. Velo is the leading nicotine pouch in Europe with a market share of around 60% in the Nordics where the category is really popular. Velo is the market leader in Europe (Capital Markets Day Presentation)In the US, however, Velo failed to gain traction so far, since BTI is only allowed to sell an inferior product due to regulations. That might change soon, as we're going to find out later. New Categories Are More Profitable Than Cigarettes Now here comes a point, that should be really important for long-term tobacco investors. So far, NGPs have been shown to be more profitable than cigarettes, which is already one of the highest-margin consumer products there is. Capital Markets Day PresentationModern oral seems to be the most profitable, but heated tobacco and vaping are also more profitable than cigarettes. Now, I always take investor presentations with a grain of salt, as, in the end, those events could turn out to be sales pitches for the stock. But if we check the current results for Philip Morris, it shows NGPs are indeed more profitable than cigarettes. If you compare the profits made from IQOS and Zyn to cigarettes, PM earns more per unit from them than with their premium-priced Marlboros. Pretty impressive. However, one must keep in mind that PM already reached scale with their NGPs, and they're less taxed than cigarettes. If governments around the world wake-up to the fact, that NGPs are becoming more popular, my best guess is that taxes will rise. For BTI to reach similar scale, it'll take some time and further innovation, which will result in higher R&D costs. But nonetheless, NGPs do have the potential to at least replace cigarettes' profits in the future, if BTI will be able to gain market share. British American Tobacco Is Stepping Up Innovation In my last article about BTI, I said the company needs to step up their innovation in order to compete against PM and emerging companies. It seems like BTI has listened, as the Capital Markets Day was all about innovation and speed to market. BTI is investing in innovation (Capita Markets Day Presentation)BTI has doubled its spending in innovation since 2021 and now has three innovation centres around the world. The early signs of their investment can be seen in the fact, that the company was the first one to introduce non-tobacco heat sticks for their Glo devices made out of tea, PM has followed suit since. BTI also was the first company to introduce a display to a heated tobacco device, which seems to resonate well with consumers, as BTI stopped losing market share since the launch. First heated tobacco device with a colourful display (Capital Markets Day)I've been following BTI for quite some time now, and innovation and speed to market really have picked up in the last couple of years, although there's still room for improvement to effectively compete against nimble smaller players and Philip Morris. Maybe we're getting closer for BTI to reach that point, as the company released insights into future innovations for all three NGP categories. British American Tobacco's NGP Innovation The first innovation is the Vuse Ultra, that should be introduced soon in many of the most important vaping markets, except the US. The Vuse Ultra looks a lot like the recently released Vuse Go Reload, but with a display. While I think it's cool to have a display that shows the battery life, it's probably not a groundbreaking device that will shake up things in the vaping space. Vuse Ultra (Capital Markets Day)Disposable vaping devices are increasingly an issue, and they're getting cheaper if you're measuring it in price/per milliliter liquid. For example, when the Chinese vapes started to become popular a few years ago, they were filled with 2ml nicotine liquid, which for a heavy smoker would last one day. Those did cost around $10. Nowadays, you can find in many countries disposable with ten-times more liquids and fancy displays. Those will last heavy smokers roughly 10 days, and they cost somewhere around $20-30 or just $2-$3 a day. It will become increasingly difficult for BTI to compete against that, if the illicit Chinese vapes will be able to stay on the market. Innovation in Heated Tobacco The most eye-catching innovation has been the latest Glo Hilo, which BTI shortly introduced on the Capital Markets Day. They didn't offer much information about it, since it hasn't been released yet, but it looks like a winner to me. By talking to many IQOS users over the years, why they wouldn't use Glo, the main answers I got were:  It's too heavy in my hands. It's a pain to clean. It tastes worse than IQOS.  It seems like BTI has found a solution to the first two issues. With the Glo Hilo they're going to introduce a two-piece device for the first time. This looks a lot more like IQOS and I think it should resonate well with consumers. The two-piece device will probably reduce the weight, which seems to be a huge pain point for consumers. BTI also released sealed sticks in Japan recently, which should make cleaning the device a thing of the past, as tobacco can't get stuck in the device. Glo Hilo (Capital Markets Day)BTI will also introduce a one-piece device of the new Glo Hilo. It looks a lot more premium to me than previous generation models and that's exactly what BTI targets going forward, the premium consumer. While heated tobacco makes the money on the consumables, not the devices, a premium product should attract more long-term consumers who are willing to pay premium prices for the consumables. Makes sense to me, and I think BTI is finally starting to head in the right direction with these new devices. Innovation in Nicotine Pouches BTI came out with a new premium design of Velo, which seems to have a more comfortable shape. It's encouraging to see innovation in this space and along with a wider variety of flavors should help BTI to keep leading the category in Europe. Premium Velo (Capital Markets Day)On top of that, BTI will introduce a new Velo Plus version in the US. This comes in a wider variety of flavors and nicotine levels. It's based on synthetic nicotine, and it's probably going to resonate better with consumers, as the current product on the US market isn't very popular at all. In fact, BTI's current US version is disappointing. BTI bought Dryft a couple of years ago and rebranded it Velo. Its flavors don't last too long and there always seems to be pouches that are broken up and powder is everywhere in the can. Both huge pain points for consumers. I think this could improve with the new Velo Plus. BTI also filed a PMTA for its popular European version, hopefully they'll be able to sell it in 2026 in the US. I believe its European version is far superior to the current US version, and it should be able to compete with the market leader Zyn. New Velo Plus (Capital Markets Day Presentation)Conclusion Those were the most important news BTI showcased on its recent Capital Markets Day. I've been watching the company a while and when I began investing into BTI a couple of years ago, I didn't believe they would have a good chance to compete in NGP. I was confident cash flows from cigarettes alone would justify the valuations the stock was trading at back then. However, it seems like BTI is really committed to becoming a more agile and innovative company. If they can continue their pace, I think their future could be bright even beyond cigarettes. The company believes nicotine will have a profitable future, and so do I. Management expects to return to mid single-digits operating growth beginning from 2026. I don't see any reason why this shouldn't be achievable if they stay on track. Given that cash flows from cigarettes should remain stable for some time and BTI is stepping up its innovation, the current valuations don't seem to make much sense to me. I'll keep buying shares every week and still rate it a 'strong buy'.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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