British American Tobacco

Theme and Background

This chapter examines Bireme Capital's core rationale for investing in British American Tobacco. The backdrop is that European ESG investment trends have led to tobacco stocks being systematically undervalued by the market, while BAT's traditional business remains stable and its “reduced-risk products” segment is growing rapidly, albeit with lagging market perception.

Core Thesis

The author argues that due to widespread “social herding bias” among European investors, tobacco stocks like BAT are mispriced, with the current valuation of only 8x free cash flow offering a highly attractive investment opportunity. The counterintuitive judgment is that BAT is not a sunset industry; rather, owing to its leading position in reduced-risk products, it may in the future be regarded as a socially responsible enterprise and undergo a valuation re-rating.

Key Arguments and Data

1. Market Bias and Mispricing:

• A 2022 PwC survey found that 60% of European fund managers plan to stop launching ESG-noncompliant funds by the end of 2024.
• Against this backdrop, despite steady profit growth, BAT's share price has fallen about 40% over the past five years, significantly underperforming the S&P 500 and the MSCI World Index.

2. Cognitive Gap in Reduced-Risk Products:

• Public Health England confirmed in reports from 2015 and 2022 that vaping is “at least 95% less harmful” than smoking.
• Yet market perception lags—only one-third of respondents in a UK study correctly recognized that e-cigarettes are less harmful.

3. Resilience of the Traditional Business (Combustibles):

• Since 2018, BAT’s revenue has been stable at around £24 billion.
• The author conservatively predicts future combustible tobacco revenue will decline at 2% per year (volume decline of about 5% offset by annual price increases of 3%).

4. Growth Prospects of Reduced-Risk Products (NGP):

• This business is BAT’s “crown jewel,” holding dominant market shares in e-cigarettes and “modern oral” products in many countries.
• The company expects NGP revenue to reach £5 billion by 2025, with a compound annual growth rate of 33% over the past four years.
• The author forecasts NGP sales will grow from £2.9 billion in 2022 to £12 billion by 2030, lifting total company sales from £27.7 billion to nearly £30 billion.

5. Market Performance of Key Brands:

• Vuse (e-cigarette): Market share in its top five markets grew from 16% in 2019 to 36%. In the first half of 2023, the vapor business gross margin reached 58%, approaching levels of other products.
• Glo (heat-not-burn): Category market share increased from 12% since 2020 to 20%. In Japan (one of the world’s largest markets), heat-not-burn products now account for over 30% of the market.
• Velo (modern oral): Dominates the modern oral market in Europe and is expected to be the fastest-growing sub-segment.

6. Profit Potential of the NGP Business:

• Strong unit economics: According to analyst estimates, the manufacturing cost of a vape pod is $1–2, while a pack of cigarettes in the U.S. sells for $6–9. If priced at $8, even after wholesale discounts and certain state excise taxes, gross margins could reach 70%.
• Industry precedent proving profitability: Philip Morris International’s IQOS product (heated tobacco) generated over €12 billion in sales last year, accounting for about one-third of the company’s revenue, with a stable EBITDA margin of approximately 43%, demonstrating that the NGP business can be very profitable.

Companies/Assets Involved

• British American Tobacco (BAT): Bullish. A global tobacco company with traditional brands such as Kent, Dunhill, Lucky Strike, Newport, and Camel, and a dominant market position in reduced-risk products including Vuse, Glo, and Velo. It is predicted to benefit from NGP growth and potential valuation re-rating.
• Philip Morris International (PMI): Referenced as a benchmark case. Its IQOS business has achieved scale profitability with an EBITDA margin of about 43%, providing supporting evidence for the profitability outlook of BAT’s NGP business.
• Juul: Mentioned as a market competitor whose U.S. market share is being displaced by BAT’s Vuse product.

Investment Implications

For investors, this means the opportunity to buy a company with stable cash flows and a dominant position in a new growth track (reduced-risk products) at a very low valuation (8x FCF). While waiting for a shift in market perception that could lead to a valuation re-rating (possibly to 15–20x P/E), investors can collect a generous and growing dividend. The investment thesis rests on the divergence between market sentiment bias and the continuous improvement in the company’s fundamentals.

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Theme and Background

This chapter provides an in-depth analysis of the profit potential and regulatory risks faced by tobacco giants such as BAT in the "Next Generation Products" (NGP) space. The core context is that NGP (e.g., e-cigarettes, nicotine pouches), as substitutes for traditional tobacco, have profitability and growth prospects that are becoming key determinants of tobacco companies' future value.

Core Thesis

The author argues that BAT's NGP business is not only growing rapidly but also possesses high profit potential (incremental EBIT margin above 40%) and significant industry entry barriers. While a potential U.S. menthol ban poses a major risk, the author believes BAT's valuation already fully reflects this pessimistic outlook, and the successful transformation of its NGP business will drive long-term value, with the current share price offering an attractive risk-reward profile.

Key Arguments and Data

1. High Profitability of NGP:

• Philip Morris International (PM) has explicitly stated that its NGP profitability will surpass that of traditional cigarettes.
• Swedish Match (SWMA, acquired by PM) serves as an example of NGP's high profitability. Its EBIT margin improved from 30% in 2011 to 41% at the time of its acquisition in 2022. In the U.S. market (where nicotine pouches hold the largest share relative to chewing tobacco), its EBIT margin approached 50%.

2. Entry Barriers in the NGP Industry:

• Brand Loyalty: As first movers, large tobacco companies have established brand loyalty.
• Regulatory Burden: Approval processes by regulators such as the FDA create entry barriers.
• Distribution and Marketing Expertise: Incumbent tobacco companies have well-established relationships with convenience stores and wholesalers, as well as strong consumer marketing capabilities.

3. Specific Impact and Modeling of Regulatory Risk (Menthol Ban):

• Scale of Risk: A significant portion of BAT's U.S. sales comes from menthol cigarettes, and 40% of the U.S. market consists of menthol products.
• Potential Impact: Based on data following California's ban (Barclays estimates BAT's cigarette sales volume in California declined by approximately 30%), the author assumes in the model:
• A nationwide U.S. menthol ban is implemented in 2026.
• BAT's menthol sales volume will decline by 50% (the other half of consumers switch to non-menthol versions or competing products).
• This sales volume loss results in a 60% margin erosion.
• Regulatory Uncertainty: The FDA has issued a "marketing denial order" for BAT's Vuse brand menthol pods, but the author believes menthol e-cigarettes will ultimately receive broad approval in the U.S.

4. Financial Forecasts and Key Assumptions:

The author models BAT's investment returns using a base case and an upside case.

Base Case Key Assumptions and Results:

Assumption	Specific Parameter
Annual decline in traditional tobacco (ex-menthol)	2%
U.S. menthol sales volume decline (2026)	50%
Near-term growth rate for smokeless products	25%, gradually declining to 12% by 2030
Incremental EBIT margin for smokeless products	40%
Combustible product operating margin	Gradually declines from 51% to 44% (affected by the ban)
Terminal P/E in 2030	11x

• Forecast Results: Operating profit declines slightly from £12.4 billion in 2023 to £11.9 billion in 2030 (primarily due to the menthol ban), with profit recovering after 2026. This model yields an internal rate of return (IRR) of 16.3%.

Upside Case Key Assumptions and Results:

Assumption	Specific Parameter
No U.S. menthol ban implemented	-
NGP revenue CAGR	20%, reaching £13 billion by 2030
NGP incremental margin	55% (terminal operating margin 36%)
Combustible product margin	Remains at 51%
Stock valuation multiple	Close to the market's 15x P/E

• Forecast Results: Operating profit rises to £16 billion, IRR reaches 24.1%, and the initial investment could quadruple within 7.5 years.

Companies/Assets Involved

• British American Tobacco (BAT): Bullish. The core subject of the report; the author believes its NGP transformation will create value, and its current valuation (approximately 8x free cash flow) is attractive.
• Philip Morris International (PM): Used as a reference case to illustrate the high profit potential of NGP and industry trends.
• Swedish Match (SWMA): Used as a reference case; acquired by PM, serves as a successful example of NGP's high profitability and scale effects.
• ITC Ltd.: BAT holds a 30% stake in ITC. The company trades at historically high levels in India, with a market cap of approximately $25 billion and a 25x forward P/E. The report notes that BAT's stake, while valued highly in the Indian market, is attributed only about 7x by UK investors, creating potential value realization opportunities for BAT (e.g., selling shares to pay a special dividend, or waiting for ITC's profit growth to justify the high valuation).

Investment Implications

1. Investing in BAT is essentially investing in the success of its NGP transformation: Investors should focus on the growth rate of its smokeless product revenue and the improvement in profitability, which will be the core drivers of a stock revaluation.

2. Regulatory risk is partially priced in, with downside risk controlled: The model already incorporates the severe impact of a U.S. menthol ban in the base case and still yields an IRR above 16%. This suggests the current stock price may already reflect a high degree of pessimistic expectations.

3. Implied "free option": The value of BAT's stake in ITC is not fully reflected in BAT's current market capitalization, providing investors with an additional source of potential value.

4. Significant upside potential: If NGP growth exceeds expectations or the U.S. menthol ban is not implemented (or its impact is less than expected), the investment return (IRR of 24.1%) and absolute gains (4x) would be very substantial.