BAT share buyback - what's next?

$BTI

Following the partial sale of ITC stake for GBP1.57bn net proceed, BAT has announced share buyback of GBP700m for FY2024 and GBP900m for FY2025. If share price remains unchanged, the announced share buyback will reduce share outstanding by ~3%. As with many other investors of BAT, I am wondering “what’s next”? For people who believe BAT shares is undervalued and hence share buyback provides a good opportunity to create value, there’s another angle to look at this capital allocation decision and assess the forces that steer the direction of which.

Given BAT embraces a progressive dividend policy, i.e. dividend per share has to increase yoy in sterling term, the discretion by the board to declare a dividend has almost become a de facto obligation in reality. When dividend payment becomes an obligation instead of a discretion, from the company’s point of view, its 2.236 billion shares outstanding behaves more like a perpetual bond rather than common equity. Just imagine you are Soraya Benchikh, the incoming CFO of BAT who will join the company from 1 May 2024, and you are tasked to review the capital structure of the company, then you will quickly figure out that this “perpetual bond” has an interest rate step-up feature owing to BAT’s commitment to a progressive dividend policy. And now imagine you need to refinance BAT’s outstanding debt and need to present BAT’s credit strength to a credit rating agency, the credit rating agency will then need to calculate the free cash flow available for debt payment. From the credit rating agency’s point of view, the cash flow available for debt payment is not GBP8.4bn, the free cash flow generated by BAT in FY2023. The number that really matters is free cash flow after dividend. Hence at the prevailing market condition when BAT is trading at 9.7% dividend yield, it is almost as if BAT has an outstanding perpetual bond of GBP54bn that comes with 9.7% coupon and interest rate step-up feature. For shareholders and bondholders who care about increasing cash flow available for debt payment, is it more effective to redeem the perpetual bond that comes with 9.7% coupon and interest rate step-up feature or reduce debt that comes with 6.2% yield (referece to yield of BAT’s bond with 10.5 years to maturity, similar to the group’s average debt maturity)?

With the aforementioned backdrop, let’s take a look at some numbers and recent events to see the cards that are being dealt to Soraya Benchikh. Here we go.

1. Cadence of share buyback - 2022 vs 2024 ytd

Source: BAT stock exchange announcement

• The chart above summarises the cadence of BAT’s sharebuyback in FY2022. The share buyback activity was spread over the entire year. From 14 Feb 2022 (first day of share buyback) to 24 Jun 2022, GBP14m worth of shares were repurchased per trading day. From 27 Jun 2022 to 14 Dec 2022 (last day of share buyback), GBP6.3m worth of shares were repurchased per trading day. A total of GBP2bn worth of shares were repurchased as promised by the management.

• From 18 Mar 2024 to 28 Mar 2024, GBP6.9m worth of shares were repurchased per trading day. Unless BAT slows down share buyback pace, the GBP700m share buyback scheduled for FY2024 will be completed in 101 trading days, which is 18 July 2024. If this happens, share buyback will stop abrutly in mid July with no further buyback scheduled for remainder of the year. How does that look?

2. Fitch upgrades British American Tobacco to 'BBB+'; outlook stable

   Below are extracts from Fitch’s rating upgrade. It is helpful to read the full article but I extract below some key messages for your easier reference.

   Note how they assess the FCF on a post-dividend basis. While they acknowledge BAT’s share buyback plan, it is important to note that it shall not deter BAT from its stated leverage target.

   Strong Cash Generation: Our rating case suggests annual post-dividends FCF will remain strong at GBP1.7 billion to GBP2 billion over the next four years, supported by low single digit organic revenue growth, the EBITDA margin improving towards 49% from 47% in 2023, aided by new categories, anticipated double digit strong growth and further efficiency savings in 2024 and 2025.

   We estimate this cash generation will allow additional shareholder distributions and assume potential share buybacks of up to GBP3.5 billion over 2026-2027, in addition to announced combined GBP1.6 billion buybacks for 2024-2025. We acknowledge the company follows an annual dynamic capital allocation strategy and expect any potential distributions will not compromise the stated leverage targets.

   Below are factors that Fitch may consider for rating upgrade / downgrade. Note that credit rating is not solely about net debt to EBITDA. Even net debt to EBITDA is not limited to debt repayment. Things that matter include NGP category contribution that relates to EBITDA growth, menthol ban that may lead to lower profit and FCF margin (post-dividend) that is impacted by dividend payment and some other factors that are self explanatory.

   Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade:

   • Good progress towards NGP category target increased revenue contribution leading to sustained organic revenue and EBITDA growth;

   • Net debt/EBITDA towards 2.0x on a sustained basis;

   • Maintaining FCF margin at around mid-single digit;

   • Operating EBITDA/interest coverage above 8x.

   Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade:

   • A material impact from the menthol ban in the US and a loss of market share, or an inability to achieve profitability for next generation products as combustible volumes decline, competition for NGP intensifies, either of which results in lower profits leading to FCF margin declining under 4% of sales;

   • Net debt/EBITDA above 3.0x on a sustained basis;

   • Operating EBITDA/interest coverage below 6.5x.

   Based on Fitch’s credit rating metric, BAT’s net debt to EBITDA ratio was 2.8x as of Dec 2023 after taking out restricted cash and profit in Canada. If BAT writes off its Canada business, it won’t have impact on its credit rating. However, there’s still a possibility that BAT may wish to keep their Canada business by paying a settlement amount that is larger than the restricted cash in Canada, which may compromise share buyback projected for 2026-2027.

   Litigation Impact Well Managed: Our rating case models a "limited downside risk" approach, assuming no value remaining in the Canadian operations for BAT as result of the litigation. However, we have also removed all cash uncertainties associated with the legal proceedings in our rating case. This deconsolidation results in an increase in net EBITDA leverage of approximately 0.2x.

   We estimate that in case of a material cash liability arising as a result of the litigation resolution in Canada, materially exceeding the level of cash generated by the Canadian operations, and BAT's decision to support the subsidiary, the value allocated to the potential share buybacks of up to GBP3.5 billion projected for 2026-2027 may be redirected to meet this obligation. Together with BAT's estimated on-balance sheet cash, excluding the Canadian operations, this should still provide a sufficient liquidity pool in our view.

   Before Fitch’s rating upgrade, Tadeo Marrocco also made the following comments during a a fireside chat at UBS Global Consumer and Retail Conference, which is more or less in line with the credit rating agency’s message.

   The credit ratings agencies, though, as soon as we enter in CCAA, they have already stripped out the whole Canada business from BAT numbers. And they have their own metrics and targets for us. That's the reason why, from their perspective, our leverage is higher than the 2.6x. But we have also made progress on their own way to measure our leverage, to the point that S&P more recently upgraded us from a negative outlook to stable. The other two agencies actually moved us to a positive outlook, which proves that our capital strategy has been the right one. So, we have been providing more and more visibility in terms of the cash and cash equivalent positions that we have today in Canada, which is around £2.4 billion by the end of last year. And also, all the earnings is in our prelims (ph), in order to make sure that investors has all the information. Because the best way to treat this potential outcome is through what the credit ratings agencies does, which is basically taking the whole numbers of Canada out. In doing that, we'll probably have to face a headwind today, but this varies a lot as well. But today would be around 0.3x

3. ITCAN - Stay Extension Order issued on March 25, 2024

• A Stay Extension Order was issued on March 25, 2024, extending the stay of proceedings up to and including September 30, 2024.

• Until then, the Court-Appointed Mediator, with the assistance of the Tobacco Monitors, will continue to conduct the Mediation, facilitate the exchange of information, and engage in meaningful discussions with the Mediation Participants.

• The settlement amount remains undetermined as of the latest.

4. Delay of U.S. menthol ban

• The Biden Administration delayed issuing a final rule in December and now has missed the new deadline it set to issue the rule by March 2024

• It looks increasingly likely that White House may wait until after the election to make a decision. If it does, a potential GOP-controlled Congress and second Trump administration could undo the rules through the Congressional Review Act.

5. Nielsen data through March 23, 2024

• BAT U.S. cigarette market share for the latest 4 weeks remained at 30.2%, decreasing by 43bps yoy but no change vs February 2024. Dollar sales declined by 7.0% yoy while volume declined by 10.6% yoy.

• Vuse market share for the latest 4 weeks at 41.6%, decreasing by 60bps vs February 2024. Dollar sales declined by 10.5% yoy while volume declined by 15.2% yoy.

• As the Nielsen data suggested, BAT’s U.S. cigarette business has not yet seen an inflection point, while its e-cigarette business continues to decelerate, probably due to proliferation of illicit disposable vapes.

Conclusion

When it comes to mid July, should BAT halt share buyback for remainder of the year as the GBP700m planned for FY2024 is completed? Or should it increase the share buyback amount for FY2024? It will be a tough decision given weakness of its U.S. business and uncertainty relating to the CCAA process in Canada. If it chooses to increase share buyback, even if it doesn’t compromise its leverage target, it still reduces its financial flexibility to retain its Canada business as the settlement amount is unlikely to go below the GBP2.4bn restricted cash in Canada. Its Canada business generates GBP600m profit per year and the retention of which may help with or deter BAT’s leveraging target, depending on the settlement amount and industry profit pool after the settlement (if there’s significant increase in excise tax). For example, it could be a one-off settlement, multi-year settlement (similar to Master Settlement Agreement in the U.S.) or a combination of both. Fitch has assumed GBP3.5bn additional payment on top of the GBP2.4bn restricted cash in Canada, i.e. GBP5.9bn in total should BAT decide to retain its Canada business. But I think it is too early to tell until there’s further progress in the CCAA process and mediation with various stakeholders in Canada.

Of course, if BAT has headroom to increase the share buyback amount due to better than expected profit growth but decides not to do so, then such decision will be indefensible due to the high “interest rate” of its “perpetual bond”, unless the “interest rate” decreases by then due to share price appreciation. But in any event, the capital allocation decision of BAT is subject to various constraints, which limit the variety of strategic options the company may pursue. While such limitation is bad for other industries, it may not be a bad thing for a company operating in the tobacco business. Afterall, as history suggests, tobacco companies are more likely to thrive than not if they don’t do anything stupid.