British American Tobacco (NYSE:BTI) (OTCPK:BTAFF) or BAT for short, hasn’t seen much movement since I last wrote about it in February. It’s up by less than 2%, which doesn't compare well with the 7.1% rise in the S&P 500 Consumer Staples Index during the same time. It has hardly just underperformed the index, though. A year-to-date [YTD] comparison reveals that it has lagged behind its peers as well (see chart below).
The BAT edge
Still, it's not all bad. Not after a 27% price decline in 2023. By comparison, the YTD increase is encouraging. It's also in line with my Buy rating, after the company's revenue growth was in line with guidance for the full year 2023, with particularly strong new categories' growth.
New categories' share second only to Philip Morris (PM)
There were two other reasons why new categories were encouraging too:
- The segment started contributing, though in a minuscule way, to operating profits, two years ahead of schedule (see chart below), in 2023. This added to the company's operating margin at constant currency at an already robust 45.7%.
- The share of new categories in revenue rose by 1.8 percentage points to 12.3%. This isn't the most impressive progress, for sure. Philip Morris for example, gets 39% revenue from smoke-free products. BAT is still, however, far better than other tobacco peers like Altria (MO), whose only answer to non-smokeable products right now is oral tobacco, with a 3.7% revenue share in the first quarter of this year. Further, the company's UK-based peer Imperial Brands (OTCPK:IMBBY) saw a 3.9% share from the segment in the first half of 2024.
High dividend yield and competitive P/E
Further, based on the company's projections for 2024, the forward dividend yield at 9.8% was robust too, and at 9.6% now, there's still nothing to complain about.
Its forward non-GAAP price-to-earnings (P/E) ratio at 6.6x looked exceptionally attractive as well, compared to both its own five-year average of 8.7x and to peers. The same trend remains even now. It's still trading at a multiple of 6.6x, while the five-year average is at 8.5x. Imperial Brands trades the next closest, and even that has a ratio of 7.4x.
The question
The question at this point is less about whether BAT can continue to generate returns for investors, but how much those returns can be. We already know that the dividend yield is substantial. Even with a price decline last year, they aided in positive total returns. But the positive price returns so far this year indicate that total returns can be even higher. The question then is, can fundamental drive higher price returns this year and beyond, especially from the growth driver of new categories?
Vuse's expansion continues
To this extent, it's heartening that in its latest trading update, the company continues to provide an encouraging picture for the segment. The performance of its vape brand Vuse and Velo, of nicotine pouches, is particularly encouraging.
Vuse has seen an improvement in penetration to 41% among the big seven vapour markets of the US, Canada, UK, France, Germany, Poland and Spain, which account for 80% of the segment's revenues. It had a leadership position even earlier, but it has risen from 36% in 2023 (see chart below).
The Americas and Europe [AME] market, which accounts for 38% of the company's total revenues, is promising in this regard. It saw a small uptick in Vuse's market share, especially due to poly-usage, which refers to transitional smokers that consume both smokeables and new category products.
Velo, BAT's modern oral brand producing nicotine pouches also deserves a mention when talking about the growth in new categories. Not only are the second of the two brands in the segment, but the other one being Vuse, to be profitable, its market share is increasing as well. The latest trading update puts the volume share at 10.3% in key markets, up from 8.6% for the full year 2023.
Meeting the US market's challenges
However, the promise of new categories is not without challenges. The biggest one being its massive US market, which accounted for ~44% of BAT's reported revenue in 2023.
For example, Vuse saw a 90 basis points [bps] decline in value share in the market according to the latest update. Even with the brand's still robust leadership position in the market, with a 51.5% share, it expects "financial performance will be impacted by the continued growth of illicit single-use vapes".
The background to this is the proliferation of illegal Chinese vapes in the US market. In its insightful take on the evolution of the vaping market, Tidefall Capital Management's recent fund letter talks about how Juul's commercialisation in 2015 and its exceptional growth improved the prospects for tobacco stocks as such. But, importantly, it adds:
The increase in teen usage pressured regulators to force Juul and US vape manufacturers to withdraw their enticing flavours. This product gap left vape users searching for a replacement. Nearly all users transitioned to illegal Chinese disposables that are now widely available at the approximately 10,000 independent cigarette and vape shops in the US."
Now, however, things are beginning to look up for legitimate producers like BAT. Vapour directories are being established, which would stop illegal sale of these products. Twenty US states have enforcement bills underway in this regard and three have enacted them already. Vuse is already beginning to benefit from tighter laws in Louisiana, the first state to enact directories in last October.
But there's still the obstacle of marketing denial orders [MDOs] by the US FDA in its way. It's the tighter regulation that led to market capture by illegal vapes in the first place. In my recent article on Imperial Brands, I had pointed out the marketing denial orders for its next-generation products, which led to holding back on investments and a 25% plunge in revenues in H1 FY24 (for its financial year ending September 30, 2024).
BAT's case is no different. Last October, it had to stop selling its popular menthol flavoured Vuse Alto vape, among some others, on the FDA's orders. And while the brand continues to make progress overall, this does impact the extent of sales possible, especially at a time when pivoting to non-smokeable is key for the continued sustainability of tobacco companies.
What next?
The discussion on new categories reveals that while there's definite upside for BAT, whether it can materialise fast in the near future remains to be seen. To be fair, the company does expect growth in the segment to be weighted towards the second half of the year. But even then, only "low-single figure organic constant currency revenue growth" as a whole is expected for the full year.
This, coupled with the company's ongoing regulatory challenges in its big US market, can continue to drag down the growth potential. Still, its robust adjusted profit margins make it an attractive stock, even among its industry peers. And the dividend yield looks good too. I would have been more skeptical if there was any change in the outlook or if there was weakness in the performance of new categories, but there isn't. So, I'm retaining a buy on British American Tobacco.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
