British American Tobacco - a closer look into the U.S. business
Since the announcement of pre-close trading update on 6 December, share price of BAT has dropped by 8%. This is mainly driven by BAT’s decision to take an impairment charge of around GBP25bn relating to its U.S. cigarette brands acquired in 2017 following merger with Reynolds American. This even invites “investigation” from a class action law firm Pomerantz LLP. I don’t have much to comment on the pre-close trading update as Devin Lasarre already published an article that well summarised the situation and provided his view on this.
I have re-invested the dividend I receive from BAT and sold my stake in META / NFLX / ALGN to finance the purchase of BAT shares throughout the year. While for last year, I didn’t buy any BAT shares when it was trading above US$40 for most of the time. Voilà, my shareholding in BAT has increased by 84% since the beginning of 2023 and I am quite okay with that. It gave me similar level of comfort as the decisions of buying NFLX, META, TSM and ALGN last year.
As with everybody else, I have been scratching my head to figure out two questions about BAT’s U.S. business.
What has gone wrong?
What could have been done to “right the wrong”, and why didn’t it happen?
To answer these questions, I want to look at the fact first. Here we go.
U.S. business revenue and operating profit
While BAT reports its U.S. business operating result in GBP, it is subject to FX movement. For easier comparison against Altria, I have translated BAT’s numbers to USD, using the average FX rate disclosed in BAT’s annual report.
During 2018-2022, BAT’s U.S. business net revenue increased at a CAGR of 5.4% while adjusted operating profit increased at a CAGR of 8.8%. Operating margin expanded by 660bps from 47.5% in 2018 to 54.1% in 2022.
During the same period, Altria’s net revenue increased at a CAGR of 0.5% while adjusted operating profit increased at a CAGR of 5.7%. Operating margin expanded by 730bps from 52.6% in 2018 to 59.9% in 2022.
To dissect the underlying drivers of revenue growth, let’s turn to Nielsen’s data.
U.S. cigarette data from Nielsen
Nielsen data is based on retail sales value including excise tax, while both BAT and Altria report net revenue excluding excise tax. With this in mind, let’s continue.
As you may note from the chart below, BAT dollar sales growth actually outpaced the overall industry and Altria during 2019-2021, but the trend reversed in 2022-2023. 2023 data was based a 52-week period ending 4 November 2023. Let’s break it down by price/mix and volume to take a closer look.
BAT took moderate pricing decision in 2019-2020 with ~5% price mix which was largely in line with Altria. Then in 2021, BAT became much more aggressive in pricing, increasing price mix by ~9% while the wider industry and Altria was increasing at ~7.5%. 7.5% price/mix by Altria was probably driven by affordability of U.S. consumers enhanced by Covid-19 economic relief measures during 2020-2021. From hindsight we can see that BAT volume declined sharply in 2022 and 2023, which was partly attributed to pricing decision in 2021-2022 combining with macro economic headwind in the U.S. and proliferation of disposable vapes. Why did BAT increase price more aggressively than Altria back then? Could it have done it differently?
To answer this question, let’s try to think from BAT management’s perspective. What was the step change that BAT tried to make in 2021? Let’s look at the conversation below from BAT’s 1H 2021 earnings conference call.
Karim Ladha, Partner, Independent Franchise Partners
“The market though, it's not giving you credit for this. You're trading on just 8 times EBITDA. And, at £28, there is opportunity to create enormous value by buying back stock in size and doing so before your investments in next-gen platforms start to materialise in your financial results.”
Tadeu Marroco, Finance and Transformation Director
“……But our priority right now is the dividend pay-out of 65%, continuing to invest in the business in the New Category space, like we have just done, you know in Organigram or in the companies we acquired through our corporate venture arm, and we will then pay the debt to get us to the revised corridor between 2 to 3 of leverage on the balance sheet. And then, like Jack said, we will have more flexibility to reassess capital allocation, which is something that we're doing on a constant basis.”
In light of depressed valuation, BAT was pushed by shareholders to resume share buyback after years of deleveraging following acquisition of Reynolds American in 2017. But to do that, BAT has committed to reduce its net debt to adjusted EBITDA to below 3x in order not to risk credit downgrade. And let’s not forget the mid-single figure constant currency adjusted EPS growth that BAT guided for FY2021.
In 2021, while U.S. adjusted operating profit increased by 9.7% on constant currency basis, all other segments actually fell short of the target understandbly due to COVID impact on purchasing power of consumers. Back then cigarette pricing in the U.S. market was probably the only lever BAT can pull to achieve its EPS growth and deleveraging targets in order to resume share buyback.
Since 2022, BAT has been feeling the pain of heightened volume decline and has then initiated commercial plan to stop the bleeding. In 2023, price mix only increased by 4%, far below the 6.5% achieved by Altria, partly due to more moderate pricing actions and shift of volume towards discount brands such as Lucky Strike.
Conclusion
With the above backdrop, you may see that the likelihood of achieving a different outcome for its U.S. business is quite low, even if it was managed differently. Unless the management team held a crystal ball to forsee what was to happen in 2022-2023 and hence convinced investors that securing a longer term growth trajectory was more important than achieving EPS / DPS growth and resuming share buyback in short term. Don’t get me wrong - I am not suggesting that aggressive pricing in 2021-2022 will inevitably lead to problems in 2022-2023, I just want to emphasise that what works best for the U.S. business may not always work best for BAT in near term.
To arrive at this conclusion, I have also taken a look at Reynold American employees’ review on Glassdoor over the past few years as sanity check. Please go through them if you have time as I find it challenging to summarise so many employees’ diverse opinions. Highlighted below are some “cons” of working there from employees’ perspective. While these may be true, let’s not forget the underlying constraints leading to BAT’s U.S. business having to deliver 10% growth in 2021 while a slower growth may be more beneficial to its business fundamental over a longer time horizon.
"Management changes the strategy to quick and micro management." (in 66 reviews)
"Luckily I have a good manager but I know a lot of colleagues that weren't as fortunate." (in 63 reviews)
"This leads to crippling short termism and a toxic culture to constantly acquiesce with whatever London wants even though the US market is very different." (in 54 reviews)
"Terrible upper management, very corrupt" (in 39 reviews)
After David Waterfield replaced Guy Meldrum as President and CEO of Reynolds American, there has been significant improvement in employees rating on Glassdoor. A recent review even mentioned that “"New leadership is refreshing to those that have seen recent years”. Is David more capable than Guy? Time will tell but let’s not forget the bigger picture that Reynolds American doesn’t operate as a standalone company but a subsidiary of BAT.
Exceptional analysis, Anthony. I'm continually impressed by the unique perspectives you apply - they unquestionably add meaningful value to the discussion of these companies.