British American Tobacco: You are always on my mind

[The material of the Capital Markets Day can be found on the BAT Investors webpage; unless stated otherwise, quotes are from that event.]

This blog-post is no investment advice, nor advice on anything else, and shouldn’t be read that way. I have no clue about the stock market. And if you still had any doubt about it: smoking is bad and kills. I’m glad we had that talk.

Philip Morris International is currently sporting double digit growth rates while operating in a supposedly dying industry. I prefer, however, not picking the winner, because everyone knows the winner, and instead I go down the podium until finding something cheaper. So I went through the Capital Markets Day of British American Tobacco (BAT), held on the 16th of October. I must say that everything was interesting to watch and hear, but here I just want to rehash what kept lingering on my mind.

The CEO

Having listened to Tadeu Marroco in all the presentations since he took office, I frankly believe that he is the best thing that could have happened to BAT. He is a BAT lifer, he was the CFO before, he answers CFO-directed questions better than the CFO. There is one issue, though, that I’m concerned about, and that could show him listening to the siren-song of short-term shareholders. It’s:


ITC

BAT held 29.1% in the enormously successful ITC (Indian Tobacco Company), but reduced their stake to 25.5% this year. They wanted to stay above 25% for the time being to retain veto rights on the board. BAT used the proceeds of that sale to kickstart a buyback program of its own shares, with £700m deployed in 2024, and £900m to-be in 2025. From what I understand from Mr. Marroco’s remarks about it, there has been pressure on him to bring that sale forward, and there remains pressure to keep on selling down the ITC stake: “Just on ITC, because I receive a lot of questions on ITC, there is a lot of moving parts in ITC, and India, as a market, is quite unique.” Mr. Marroco goes on to say that ITC should be viewed for what it is: an important asset for the future of the company. “And we have to be mindful that there is a foreign direct investment ban in India, which means that if you sell, you don't come back. And we do believe that there is potential for a new category growth in the future in India as well. We spoke about that.” For historical reasons, BAT has indirect access to the Indian market via ITC, but if they sell now, they can’t come back. In India, as Mr. Marroco notes, “ ... the demographics, the potential of GDP per capita growth, every type of metric that indicates future potential growth prospect, is there. It’s quite unique in that sense. So, it's a very exciting market to be associated with.” And BAT really plans to close the door further by selling more of their stake to placate short-term shareholders clamouring for a higher share-price to then sell and flip the money elsewhere? It appears so, as Mr. Marroco talked about the ongoing work of ‘unlocking’ shares for a further sale: “So, it's a very cumbersome process to go through, and we are working, like I said before, with ITC to unlock this share and having the financial flexibility for the future.” Meaning: having the flexibility to sell it down, which then gives us the flexibility to buy back more of our own shares. Because, mind you, it’s not about reducing debt: it’s about having more cash available to keep up the buyback program while reducing debt anyway with the cash flow from regular business operations. Would it be so hard to wait some more years of debt-reduction before starting a sustainable buyback program, thus safeguarding this tremendous future optionality that ITC may prove to be? Well yes, apparently it is that hard for a CEO pressured from all sides. Knowing the value of ITC, maybe, personally, he wished to be dogmatic about ITC, but he underlines that he’s not: “I'm not being dogmatic about ITC, but I'm just trying to put into perspective and from one side the attractiveness of the market, the fact that ITC is a fantastic company” — still, he’s not dogmatic, because, at the end of the day, “financial flexibility”, that is, for share buybacks, primes every other consideration.

The above discussion, of course, does not pertain to the sale of the hotel business that ITC will spin out, and shares of which BAT would be hard put to find reasons to keep: “ Well look, ITC Hotels, definitely there is no intention for us to be shareholders in hotels in India. Let's be very clear. So, whenever we believe there is the right timing, we're going to sell it.”

Innovation

When he’s not talking about his conflicted view on ITC, Mr. Marroco has a refreshingly clear language, without fluff. He doesn’t mince words, and he doesn’t underplay that a no-innovation tobacco industry has been suddenly forced to turn into a high-innovation nicotine-delivery industry. BAT will have to adapt in order to survive. On 13 March 2024 at the “UBS Global Consumer and Retail Conference” he made clear: “ … we are going through a very comprehensive transformation as a business. We came from 100 years where, for example, innovation was not a feature. If you see the combustibles [cigarette] business, we had an innovation back in the '50s, we have capsules introduced in the early 2000s, and that's it. And all of a sudden, we have to create a business that is innovation obsessive”.

And BAT is stepping up the innovation spending, as these slides show:

Still, the degree of innovation required of BAT goes beyond its own capabilities. Hence, Mr. Marroco points out that the BAT of tomorrow will be a BAT that won’t be, as before, vertically integrated: “ … different from the past hundred years, where this industry has the luxury to be vertically integrated, because we were vertically integrated. We have our farmers. We produced the leaf. We buy the leaf. We send to the GLTs [green leaf threshing]. We process the leaf. We send to the facts [factories]. We manufacture the cigarettes. We have our own distribution. We distribute 11 million points of sales on a daily basis. It's all done by us. I don't think that we in this new world, you can have the luxury in doing that. So to have the, for example, external partnerships that can complement and work in tandem with you developing IPs [intellectual property] together and developing new capabilities that will be impossible for us to do in isolation, like material science, batteries, like the BYDs and all, it's quite important”.
BAT has 50+ development partners, and two strategic partners, BYD (yes, that BYD, the Chinese Tesla contender) and aerosol-generation technology company Smoore (which, by the way, is also partnering with the U.S. Marlboro company Altria in developing its N-Joy vaping device; see my past post on Altria here):

Zafar Khan, Group Operations Director, says: “Putting both these capabilities [ours’ and our partners’] together has resulted in a very advanced ecosystem. In fact, we've now taken this to the next level with joint co-located teams at each other's premises.”

Partnerships instead of vertical integration is the new BAT. And letting the customers make themselves known instead of presumably knowing the customers, is also the aspiration of the new BAT; this with:


Unstructured data

On the Capital Markets Day many remarks were made about consumer-centric innovation, but what principally stood out to me was the focus on unstructured data: you don’t go with predefined notions into its analysis, but you let the categories of analysis emerge from it. You don’t process the data with preexisting beliefs about what the customer wants; instead, the data processing crystalises the customer wants. Mr. Marroco highlights: “there is a lot of unstructured data we need to collect, and that's where the focus is on.”
BAT’s ‘insights and foresights’ team focuses on three areas; ‘segmentation’ I consider less remarkable, but the other two are worth signaling: ‘consumer labs’ and ‘digital track’.

Julian Prynn, Global Head Consumer Insights Foresights, elaborates: “ … consumer labs. These are long-term consumer panels that enable direct authentic consumer engagement as a valuable complement to traditional and digital data tracking.”
This puts it the right way: consumer labs complement the unstructured data that thedigital track offers, as they can be sources of unstructured data themselves when you let the consumers have their voice heard and define their experience. The establishment of consumer labs, Mr. Prynn goes on, “enables us to do consumer co-creation and early-stage evaluation of innovations to enable better consumer relevance from the very start of the innovation process and to flag early signals of problems and potential benefits going forward.” If you fail, fail fast, and remedy.
And then: “ ... digital track. Digital track has been a step change for us … incorporating integrated online, search, social media and reviews … powered by AI which, for example, helps us to identify themes and to understand sentiment to make sense of powerful, what otherwise would be an overwhelming amount of data. For example, in the first 12 months we've seen half a million searches, three-quarters of a million social posts and 120,000 reviews about New Categories by consumers just in the initial 10 markets that we deployed in. Being continuous and unstructured this gives us faster insights into, firstly emerging trends, secondly, product innovation needs, delighters and pain points, and thirdly, fast post-launch tracking and competitor intelligence. Digital track enables us to provide our R&D and marketing teams with direct access to authentic consumer content in real time, a game changer for us in terms of consumer centricity and speed.”
The themes are not imposed upon the data — social media posts, reviews, etc. —, but, with the help of AI, the data articulates the themes, which helps BAT in spotting emerging trends and consumer innovation needs that they can then meet with either research and development (R&D) or marketing deployment. It’s all, as Mr. Prynn mentions, about consumer centricity, and about speed. So naturally the BAT managers in the presentations several times come back to this combination of the consumer insights&foresights and the R&D teams; Zafar Khan, Group Operations Director, underscores: “And the IP insights and foresights and science teams have been strengthened and fully integrated across all our sites.”

BAT is skillful in visually suggesting that they are actually a renewable energy company or engaged in other endeavours to save the planet:

But the central message of the video above is really this, that they want “to become a business that defines itself not by the product it sells, but by the consumer needs that it meets”. And I had the idea that this came through in the presentations at the Capital Markets Day. There is one part of that journey of transformation, though, that was not addressed:


Moonshots 

Of course, there was detailed analysis of Vuse, Glo and Velo, BAT’s flagship products in vapour, heated tobacco, and modern oral, respectively. These are nicotine products. Just one slide, though, was devoted to what I call BAT’s moonshot business arm, the beyond nicotine exploration:

Mr. Marroco remarks: “Our approach to ventures Beyond Nicotine is smart, is focused and efficient. We are not in a rush to embark at a large scale on this journey.” He makes explicit mention of energy-wellness-drink Ryde, which “has shown early signs of success in pilot markets in Australia, Canada, and the U.S.” I haven’t been able to find anything meaningful about Ryde on the Internet yet, except that BAT was accused of ‘healthwashing’.

Undoubtedly, the markets of energy drinks, CBD products and cannabis are huge opportunities; time will tell if and how BAT will choose to enter them at scale, and compete within them.

The payoff

Other than saving the world, BAT’s spending on innovation in the new products category — Vuse, Glo, Velo — has also a financially lucrative consequence, as these products carry higher margins than the already stunningly high-margin cigarette business; and cigarette margins are stunningly high even in Europe, where BAT consumers choose cheaper cigarettes than in the USA.

Mr. Marroco explains: “Now, the three New Categories are margin accretive for BAT in Europe. Heated Products consumables [Glo] are almost two times more profitable than combustibles [cigarettes]. Vapour products [Vuse] are over 1.5 times more profitable. And Modern Oral pouches [Velo] are more than four times more profitable than combustibles. And the reason for this is that BAT is historically strongest in Europe in the value for money and the low segments of combustibles, which make the size of the prize for BAT particularly high to convert combustibles consumers to smokeless offers.”

Looking at the entire world, in three years BAT has turned the new category business from unprofitable to break-even:

And now, as Soraya Benchikh, CFO, points out, the new categories business is profitable: “And by H1 2024, new category contribution had already reached 8%, as we announced in our first half results.” Unsurprisingly, she can say: “The transformation is working.” Because: “New Categories are more than offsetting the decline in combustibles and they are further driving superior profit growth. In fact, in some markets we've achieved profitability levels that wouldn't have been possible with combustibles alone.”

European markets, I gather. But what about …


The USA

Nicotine domination will be decided there, since it is the most profitable market: “The US market represents one third of the global nicotine value pool … Now, if we take a longer perspective back to 2017, when BAT fully acquired Reynolds, we can see that total nicotine revenues have grown 40%. That's up from 29 billion in 2017 to 41 now, while smokeless has grown 10 billion or 280% since 2017. This significant increase in nicotine revenues is primarily a consequence of shifting adult tobacco consumer demand for new modern product formats. Who wouldn't want to compete in such an enormous growth opportunity with scale and winning capabilities? We certainly do” (David Waterfield, President and CEO Reynolds American Inc).

So far they’ve outcompeted everyone — the legal players, that is — in Vapour, with Vuse. But where do they fall behind? In modern oral, even if, apparently, they have the better product, because wherever they have rolled out Velo 2.0 in Europe, they dominate:

But in the USA BAT only has the less enticing Velo 1.0 on the market, and Philip Morris’ Zyn is the incumbent that grows like a wild-fire (prompting savvy US politicians to make choice comments about the Zynpocalypse). The premarket tobacco product application (PMTA) for Velo 2.0 is still pending with the FDA (Food and Drug Administration); to cross the time-bridge to Velo 2.0, next year BAT will launch Velo 1.5 (yes, I’ve just made that up): “in 2025, we will introduce our Velo+ offer, which has a higher moisture profile, a broader flavour range, and more nicotine strengths” (David Waterfield).

Will Velo 1.5 aka Velo+ aka 2025 expansion be able to better compete against Zyn than Velo 1.0? Who knows.

But what about heated tobacco, where Philip Morris dominates everywhere it has rolled out its flagship product IQOS? It’s only a couple of days ago that the roll-out of test launches has been started, first in Austin, Texas; but Philip Morris will only commit to a national roll-out at scale after the authorisation of the most advanced IQOS model by the FDA – which is expected somewhen in 2025. When they are scaling up, will IQOS take share from Vapour and thus BAT? According to the theory at BAT exposed by Mr. Waterfield, this is not likely: “it's also important to note that we evaluate the complete range of US new category growth opportunities, and in regard to heated tobacco products, we remain sceptical on whether the characteristics of the US market are favourable for its development. Heated product success has been correlated to tar and nicotine content in cigarettes. Smokers with preferences for high strength combustible products in markets like Canada have been less likely to switch to Heated Products than smokers in low strength markets. And bear in mind, the US tar level is amongst the highest globally. We do not see the same opportunity for Heated Products as we do for Vapour and Modern Oral.”
US consumers prefer a high tar content, and users who do so are less satisfied with heated products; hence, heated products dominating in the new category space is not likely: so goes the argument. Starting from 2026, with IQOS expectedly in full swing in the USA, this argument will be put to the test. Whatever one may think about it, BAT, at any rate, won’t be sitting on its hands: “However, we have submitted PMTAs and MRTPAs for our glo products and we will be ready to compete” (David Waterfield). Still, in whichever country both Glo and IQOS are rolled out at scale, IQOS is the winner in heated products; if the announced Glo Hilo will do anything about changing that remains to be seen.

Above we’ve only talked about the legal market, and with that, actually, we haven’t talked about where the bulk of the money is. Vapour is the strongest new category in the USA. But BAT estimates that close to 70% of the total vapour market is illicit. This number, by the way, has gone up in the last years of reporting; first a rough number of +50% was given, then 60%, now 70%. Either BAT has honed down its estimate, or the illicit trade has taken market share from the licit one.
In my article on Altria I briefly mentioned that regulation can be both a risk and a bounty. The legacy nicotine players don’t want too much regulation; but arguably too little is much more harmful to their profits. Where effective regulation against the illicit trade has been enforced, BAT’s Vuse has seen an increase in volume and market share; here’s the example of Louisiana, which BAT considers the current best-in-class case in terms of regulation and enforcement:

Note the -91% drop in tracked channels. BAT estimates the illicit trade to amount to £6bn in the USA. Mr. Marroco further clarifies: “You just saw what happened in Louisiana, 91% of reduction in tracked channels, but most of the product is not sold in tracked channels. They're sold in internet. They're sold in Vape stores. But even if you have a third of this volume being enforced, this is already almost 2 billion of revenue up for grabs, and we have a lot of support and with views to grab most of it like we are seeing in Louisiana.”
A £2bn white space is certainly not shabby. But everything depends on what the states are and will be deciding; or not deciding.

KPIs (Key performance indicators)

The financial metrics the CFO has put out to measure the business against have been termed ‘growth algorithm’ and turned into a spinning disc:

Gaurav Jain, analyst with Barclays, was missing a bit of concreteness in the disc: “So just on NGP [new category] targets, like earlier, BAT used to have some targets on NGPs like five billion pound in revenue …  but you're removed on any of those targets, so how should investors evaluate your NGP progress and all the launches that we are talking of today? So how should we evaluate whether Glo is a success or not, or Vuse and Velo they are successes or not?”
It is, of course, a legitimate question, but I think the answers by the management team were convincing. Mr Marroco basically said: We simply do not know, there are too many moving parts. But what counts for us, it’s not revenue growth alone: “So we want to grow, but we want to grow with quality. We want to make sure that the top line flows through the bottom line, and I think that's the best way to measure that.” Mrs. Benchikh, the CFO, added: “ … we've designed the KPIs in such a way and given you visibility to really be able to measure … smart reinvestment, looking at return on investment and really making a very choiceful deployment of capital across the group. I think, the first few years, we were getting scale in our New Categories business and now we're becoming a lot more choiceful and really evaluating where we deploy the capital in the group.”
The hard targets are: yearly revenue growth of 3-4%, adjusted profits from operations (APFO) growth of 4-6%, £2bn savings by 2030, more than £50bn free cash flow by 2030, and a +90% conversion of profits into cash. Personally, I think this is hard enough, as targets. I like return on capital employed being one of the five metrics (see the slide above), and the CFO focusing on that in answering the question from the Barclays’ analyst.

The CFO also shared a slide with the performance metrics of the new growth algorithm as applied to the past four years:

Which is a sight that is easy on the eyes.

So much for that.

What else?

A lot more; there is a lot to unpack about this Capital Markets Day. But everyone will have taken their own impressions from it, and I limit myself to my own impressionistic take, outlined in this blog post.

And actually I don’t want to finish it without showing some windmills, right from the BAT homepage:

Also, a preserved rain forest (?):