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Welcome back to business breakdowns.
Today we are covering British American tobacco.
My guess for today is Evan Tindl,
co-founder and CIO of Byream Capital.
Now, regardless of your views
on the actual product of tobacco,
the market is one of the oldest in the world.
Evan helps us cover how that tobacco market evolved
and we go way back in time.
How the product itself has evolved
from smoking pipes to cigarettes
to what we're seeing today,
the nicotine pouch market and all the craze around it.
And we cover how you evaluate a company
where the market outlook is so uncertain.
My favorite part of this conversation
may be getting some background as to the name
of British American tobacco.
It's always one that has stood out to me
and the dynamics of international versus domestic
are truly unique in this market.
So a lot to consider here,
please enjoy this breakdown of British American tobacco.
All right, Evan, I'm excited.
We are finally breaking down British American tobacco.
It's been a name on our wish list for quite a while,
really since the beginning of business breakdown.
So excited to get to it here.
And I think we start at the top.
It's a very obvious industry in terms of what tobacco is.
But I think understanding who British American tobacco
is is a good place to start.
So maybe you could just walk us through
what they're actually selling, what BTI is made up of,
and anything else you think is really important
to just have right off the top.
British American tobacco is primarily selling tobacco,
surprise, surprise.
And they are roughly 50%, 45%, 50% US,
a third Europe and the rest Asia.
And profits are probably a little bit more
weighted towards the US.
They have about 24 billion pounds of traditional tobacco sales.
That's primarily cigarettes, also some cigars,
also some chewing tobacco.
And then they have three billion of what's called
reduced risk or new category products,
which are modern oral products,
which are just a nicotine pouch that delivers
the nicotine directly to your mouth,
vaping products, which people in the US are probably
familiar with, and then a heated but not burned tobacco
product as well, which is technically tobacco,
but it's not burning the tobacco in your mouth.
It's just heating it up just enough.
And so within those 24, 25 billion of traditional tobacco
revenue, they have some pretty well-known brands,
especially in the US.
Most of the top brands that aren't Marlboro
are British American brands, it's Newport, Camel, Kent,
Dunhill, Paul Mall, Lucky Strike.
Those are some of the main brands and we'll get into
the history, but a bunch of those they acquired
the acquisition of RJ Reynolds.
Between 2004 and 2017 is when they slowly consolidated
control of RJ Reynolds over time.
I knew we're gonna get into that innovative product
category, but just to hear the split of 24 versus three
is interesting.
I can imagine which one's growing faster at this point.
But let's get into that history a bit from my sense
of the research, looks like this has become a consolidated
industry over the years and you have major players.
What does BTI look like basically start to finish
and maybe in the context of the industry as well,
if you have any general market share numbers
or anything you could share around that?
So the thing with tobacco is you have to go kind of back
a long time.
So British American was formed in 1901.
I'm gonna take us back to thousands of years BC
if you don't mind.
Oh yes, we love history.
Yeah, so tobacco was used amongst Native American tribes,
both North American and South American tribes
for thousands of years before Columbus got there.
It was used for all sorts of different reasons
as various rituals, as like community building,
just to get high, basically everything that you can think
of that you might use a product like nicotine for.
When Columbus first landed in the New World,
he was actually given some dry tobacco leaf
when he first got there as kind of like a present.
So you can see how kind of important it was
in some of those societies.
But as far as the company and commercialization history
is sort of European focused, that really started,
especially in the colonies with John Rolf
who planted the first tobacco plant in Jamestown in 1612.
And it sort of might be underappreciated how important
that was for kind of the development of the colonies
because it turned Jamestown from a rag tag group of people
who like in one year, only 40 people
at Jamestown survived.
But then with tobacco, it was turned into an actual
like financially sustainable colony.
And then basically tobacco was off to the races
in the US, came side by side, the slave trade as well
over the next couple hundred years.
Then it'll fast forward us 250 years.
The tobacco industry grew primarily loose leaf tobacco sales,
chewing tobacco and pipe smoking were common.
But then in 1880, a device was created
called the Bonsack device, which took the production
of cigarettes from a couple hundred per day
to 70,000 per day.
So it basically decreased the cost of producing these things
by more than 50%.
And the guy that bought the first machines decided,
his name was Buck Duke, which just sounds like a guy
from the 1800s.
Of course, Buck Duke is gonna try to create
a tobacco monopoly, right?
Like it just sounds like what he would do, right?
And he did it well.
He did it well.
He bought these devices.
He spent a bunch of money on advertising,
which was an innovation back at that time,
creating some of the first early brands.
And in 1889, he formed something called the American
tobacco company, which was essentially a monopoly
on tobacco production and sale in the US.
You'll notice we're getting kind of close to 1901
or 1902 when the AT was created.
And so in 1901, this guy, Buck Duke decided he was gonna take
his business and try to go compete
with the British manufacturers in England.
And they didn't like that, unsurprisingly.
So they kind of circled the wagons
and 13 British companies formed what's still known
as Imperial tobacco.
And they decided to fight off ATC from the US
in every way possible by pressuring UK retailers
not to sell their stuff.
They actually came over to the US and tried to start buying
stuff in the US just so like mess with them
on their home turf.
And they spent a year doing that and then pretty quickly
they decided, you know what?
Instead of fighting each other,
let's just agree to have our own monopolies
on our own domestic turf and then create a third business,
a joint venture that would sell our products overseas.
And that was British American tobacco.
So you can kind of understand now where the name comes from.
It literally was American tobacco and Imperial tobacco
creating a combined company.
For a long time, British American tobacco was,
that was their thing.
They were selling Imperial and American tobacco brands overseas.
And it took them a few decades before they started
to get back into.
There's still not a major player in the British market,
but over time they did enter the US market.
And they did that by buying a company called Brown and Williamson.
I think that was in the 60s or 70s.
But by then the US had become a more competitive market
because in 1911, the Supreme Court ruled that American tobacco
was an illegal monopoly and broke it up
into three different companies.
The lesser disgust of the standard oil
versus the American tobacco.
It wasn't the first company that this happened to,
but it had this playbook for kind of breaking things
into its parts.
American tobacco was founded in 1889
and the Sherman NHS Act was passed in 1890.
So I don't think that was a coincidence.
But over the decades, in the US,
you had various brands that were introduced.
One of the first successful brands was introduced by R.J. Reynolds
would later become owned by British American.
And that was camel in 1913, which was one of the first national brands.
So over time, R.J. Reynolds and then later Philip Morris
became really strong competitors and came to dominate
and do really well in the US market.
They began to navigate a sort of increasing regulatory environment
because in the 1950s, a bunch of studies came out.
And that was also when the Surgeon General first sort of declared
that there was this strong correlation with lung cancer
that these companies needed to worry about.
It was at that time, in the 1950s,
that Marlboro decided to switch from being a women's focused brand
to being a men's cowboy brand.
And obviously, that is like a case study in itself
of sort of marketing prowess in 1972, Philip Morris
became the largest tobacco company in the US.
But basically, the 80s and 90s were decades of BAT,
but mostly R.J. Reynolds consolidating the US industry,
the non-Philip Morris US industry.
You had the merge with American tobacco, and I think in 1994.
They had the merge with Brown and Williamson in 2004.
They had them buy lower lard, which made Newport in 2014.
And so increasingly, R.J. Reynolds sort of gobbled up
these second and third players.
And meanwhile, British American based on the deal
to merge with Brown and Williamson in 2004,
they owned 42% of that company.
So this was largely driven by BAT strategy.
They didn't technically control the business.
Obviously, if you own 42% of something,
you have a big say and what goes on.
And then finally, in 2017, they pulled the trigger
to buy the rest of it.
So BAT took on a big chunk of debt to do that.
But then they basically became the very strong number two
player in the US number two to Altria, which is,
and there's just so many company names and mergers
and acquisitions.
It's just so complicated.
But Altria is the company that took over the Marlboro brand
because after the US really started cracking down
from a regulatory standpoint, Philip Morris
split into Philip Morris International.
And Altria, which kept the Marlboro brand
and other lesser Philip Morris brands.
Part of that, I should mention, was the 1998 master
agreement where the big manufacturers agreed
to pay $200 billion over 25 years to the States.
I think that continues to this day, $9 billion a year,
something is paid out as part of this agreement.
One of the big changes that that agreement resulted in was
the split off of Philip Morris.
So today, you have, from a combustible standpoint,
you have still Altria is the number one US company
and then a strong number two is BAT.
And Philip Morris is the biggest competitor elsewhere
and certainly in terms of next generation products,
their ICOs brand is the largest
and actually recently passed Marlboro for them
as their largest brands.
There was a lot of interesting dynamics there
that I want to hit on in terms of branding
when it comes to these companies at the highest of level
but also the individual brands as well.
But one thing that you mentioned throughout that history
was the involvement of government,
the involvement of regulation.
A few key milestones there in that history.
Can you just give us a sense of what the industry looks like
in terms of regulation today,
whether it's the taxing, the limitations on advertising,
anything else that you can point to
because it's a much different playing field
when it comes to tobacco products versus others.
The biggest thing is the companies are basically not allowed
to advertise in the US or in most developed countries,
whether that's on TV or radio or prints or really anywhere,
they're really banned from advertising.
In some ways that creates sort of a stagnation amongst
these brands which from a business perspective think
while stagnation might not be such a great thing
but stagnation if you're the number one or number two company
is not such a bad thing, right?
Because it's basically a guarantee
that there won't be upstarts trying to break
into this industry.
The idea of trying to create a new cigarette brand,
I mean, I would guess you'd get laughed out of a room
if you tried to pitch that to a venture capitalist
because it's just such an obviously terrible idea.
You can't advertise the declining population of users,
it's gonna be all sorts of pushback
and so it's just simply not possible.
And it is tax very heavily, primarily by the states,
at least in the US and of course internationally,
there's various tax regimes internationally
but like a big chunk of the price that you actually pay
for a pack of cigarettes at the store is actually tax money.
I've read somewhere, I think the industry
was 800 billion ish within the past few years
in terms of total market size and 25% of that
was going to taxes so immediately out the door.
Yeah, that sounds about right.
Quite a unique dynamic when it comes to operating
business on the market size
and just some of the trends that you mentioned there
in terms of people that actually buy cigarettes today,
it's a much different era than what it was like
when actors and actresses were seen everywhere
with cigarettes on their hand, it was almost a status symbol.
In addition to the product being hard to quit,
what has that trended like in recent years?
And you can split that up however you like.
If you wanna mention what the new products are doing
in terms of total market size but how has that market size
trended especially recently?
The thing that we have the best data on
and also probably the most interesting dynamics
is probably the US.
Historically for British American, what they've seen
the past probably five to 10 years on average
is low single digit declines in volume
and roughly similar net price increases
in terms of price per pack, which is a very convenient way
to think about the business.
And it ends up that the traditional business
has been amazingly flat the last few years.
Although 2023 was actually a larger down year
than some of the past ones in terms of volumes
with volumes down roughly 10% in the US.
But prior to that, two, three, four percent
volume declines were common and it was actually not
difficult for them because of this kind of dynamic
of it really being an oligopoly, a lot of brand loyalty.
They're historically able to raise prices
to kind of offset that pretty easily.
I'll try ahead of slide recently
that they presented at a conference that showed
that they think in terms of the volume of cigarette
equivalent packs if you include basically all forms
of nicotine has actually been growing 1% per year
over the past five years because you have this dynamic
where the traditional volume is declining,
but increasing number of people are using vapes
or using nicotine pouches or using some other form
of oral tobacco on their numbers.
They have a 1% actually growth in volumes in the US.
It gets even trickier though to actually figure out
what's going on because around 50% of the volume in vapes
is disposable non-FTA approved vapes
that can't arch-track so easily.
Like if Nielsen comes in and says,
hey, how many of these vapes did you sell?
At that point, they definitely know
that they're not supposed to give them data.
It's a little bit tricky to figure out exactly
what's going on, but rough numbers, it's sort of low.
It seems like it's either flat to slightly increasing
overall volume with the traditional combustible products
falling low single digits.
Elsewhere, it seems like it's outside of the US,
except for a few places.
There hasn't been quite as quick of an uptake on vaping,
for example.
In a lot of places, volume is kind of flatish
and price increases there can result
in actually revative increases.
One of the interesting markets to talk about is Japan
because there, you've actually seen almost 30% of revenues
now are coming from next generation,
these heated but not burned products, primarily ICOs.
And that market, the overall market has been growing
very low single digits, but the overall market has been growing.
That's like another story that I think eventually
is going to be told and people are going to realize
is that as people move to less harmful products,
the market may actually grow.
We have yet to mention the names in.
We've alluded to the pouches.
And I know Zinn is not a British American tobacco brand.
Certainly all of the craze and media headlines.
And there's some similarities to what was happening
with vaping years ago.
But when you frame the actual market sizes
or market share split between that traditional tobacco
and the new wave of products,
you gave some sense for BTI.
Do you have a sense for the market overall?
Are they a reasonable proxy in terms of their mix?
It kind of depends on exactly what you mean.
For everyone except for Philip Morris,
they have the highest penetration of,
I think it was like 16 or 17% in 2023.
It's going to be like probably more than 20% this year
in terms of next generation products.
And for everyone except Philip Morris,
that's a very high number.
I think Philip Morris is roughly 30%
of next generation products and going towards 40%.
That's sort of ex-China, I think,
because China has a huge industry
and I don't think they have any significant next generation.
Although some of the companies that manufacture
these things are actually in Hong Kong,
which is kind of ironic.
But yeah, Japan is like almost 30% share.
Europe is much lower in the US and other places.
It's 10, 15, 20%.
I think Zen is a super interesting case study.
I mean, Philip Morris is guiding for 60% volume growth.
And I think what people are discovering is that,
obviously, people have known for thousands of years
that nicotine is kind of an enjoyable drug to consume.
And what the companies are realizing
is that if people can do it in a way that's less harmful,
there's just going to be much more demand.
So I think that is maybe the canary in the coal mine
for kind of the long-term growth of the industry.
And PAT's Zin-like brand in Europe, which is Velo,
grew 35% last year.
And I think it has a good chance to continue
on sort of a Zin-like trajectory across Europe.
And maybe eventually the US, they have a Velo 2.0 product
that they're going to be launching in the US at some point
once it gets approved.
But it's not approved yet.
With something like pouches, it's something where,
I mean, almost 20 years ago at college,
I would go to a party and there would be some rep
from a tobacco company giving out these pouches for free.
So they were around then.
Can you point to what has actually led to the inflection
of interest and the demand?
I think it's a combination of things.
I think one is back in the day, back when we were in college,
the modern oral products had not been released.
So there was like, snooze products that were basically
pouched tobacco products.
Actually within tobacco products, there are cancer-causing
chemicals.
It's not just burning it in your mouth.
They're called tobacco-specific nitro-samines.
I hope I'm pronouncing that right.
And while it's definitely a lower-risk product for sure,
relative to inhaling a bunch of smoke,
there is definitely risk there.
A lot of that risk, I think, goes out the window
with the modern products, which are just pure nicotine
in the pouch.
And most of those did not get released
until around 10 years ago.
So there was that.
And then I think also similar to the popularity
of vaping in the US, once you have a product that is
a purified nicotine, it's not tobacco.
So it doesn't have inherently any sort of tobacco flavor.
You can put other flavors in it.
So you can have a mangoes in or a mint zin or whatever.
And that's just, I think, inherently more desirable products
than a tobacco flavored pouch.
So I think it was a combination of those things,
the health aspects, and the ability to more easily put in
flavors that probably is causing growth in the business.
And then in terms of those products
and the regulation around those, it's interesting because,
it seemed like zin was an upstart or part of a much smaller
company before being acquired, which
shows that there can be this path for new products
outside of the traditional cigarette space.
Are they regulated significantly differently
in terms of whether you can advertise for them
or anything else along those lines?
Zin is basically regulated, similarly
to any other tobacco or nicotine products.
They're not allowed to advertise.
They're not allowed to do all the things
that a normal company could do in terms of marketing
the products, which honestly makes its growth
all the more amazing.
It's not even fully approved, actually, in the US.
There's sort of like two buckets of these reduced risk
products, or it's actually three buckets.
One bucket is actually approved products,
which I think views enjoy and self-serve
e-liquid products where you help your own personal tank
and you refill it, et cetera, which is like a tiny percentage
of the market.
Those products are actually approved.
And then there's a chunk of products
where they are not approved, but they're still in litigation.
And the court said that it's OK for them to be sold.
Zin is one of those.
And then there's a whole group of products
that are actually not approved and not under any type
of holding pattern where they're still allowed to be sold.
That applies to pretty much all of the disposable vaping
products in the US.
Are there limits on distribution as well?
Because when I think of where you can actually
buy cigarettes, gas stations, and airports,
duty-free areas, are there other key distribution points
for these businesses?
I think as far as I know, the retailers
have to be licensed.
And typically, so the regulations are basically
similar to traditional tobacco products.
You have to have a license to actually sell it.
Arguably, the distribution prowess of filamoris
is what some people point to as sort of fueling the growth
of Zin in the US over the last few years.
Getting to the point of brand, which you mentioned,
there's a lot of brand loyalty from centuries ago.
You mentioned names like Camel and Marble.
But when you flash forward to today,
when you have a product like Zin, and you're
trying to compete with that and the media coverage
that it's getting, which is, in some ways, likely
to just attract more attention, potential users,
unless there's actually regulation and force,
how does a business like British American tobacco
try to get more loyalty towards their own brands
and their own products?
In the US, they've had a really tough time breaking
into Zin's stranglehold on the US market.
And if anything, when people ask,
because sometimes there's some pushback
around sort of the brand loyalty of vaping, for example,
people think that people will just use whatever product.
But if you look at Zin, I think what Zin shows is that,
once brands are well established, and people
started using the same thing and they like it,
it's actually pretty tough to break into that stranglehold.
And so what British American tobacco has done so far
is actually refocused on the markets where they're the Zin,
which is most of Europe that has sort of a material
modern oral business.
They're by far dominant in the Scandinavian countries,
for example, which is where the product originated.
I don't think they've explicitly said this,
but I think that they're waiting for the approval
of their Velo 2.0 products in the US
before they really put marketing dollars behind it,
because that's the product that they're selling in Europe.
That's the best products.
And so they had the Velo 1.0 here, but not the 2.0.
And so I've actually heard of Canadian hockey players
that import this Velo 2.0 product from Europe.
They like it better than Zin, supposedly.
That might just be me searching for a sign of an anecdote
that matches my bias.
I think it's a good sign for the long-term ability to compete.
That anecdote, I think, is just interesting in this day
and age in terms of who influences the purchase of things
and avoiding the word influencer, particularly in an industry
where advertising is difficult.
You did mention the distinction there
that they would spend marketing dollars.
Can you just differentiate what marketing dollars mean
when advertising is so restricted?
It's primarily in discounts to retailers.
You can also put people out into the field.
You can put physical bodies out there
to carry packs of Velo and say, go to convenience stores
and say, hey, you should be selling this.
That have better product placement, et cetera.
You can have them put something in the window
of the convenience store or whatever.
You can pay for that type of advertising.
That's common.
Almost giving the retailers free products
is one of the common ways that they spend marketing dollars.
There's an interesting category of businesses
where I think you see that.
You see the reps on the field again.
I'm going to bring up the college party example
where Red Bulls and pouches were not too uncommon
to see out there.
In Europe, what I coasted, which
was genius, was they would have sponsored events.
I think they still weren't a lot to traditional advertising
in many places, but they would sponsor events.
They would lease these retail spaces where it would be almost
like an Apple store to get people to come in and try the thing.
No one in the US has tried anything like that.
With the success of Xen, it doesn't seem
like it's necessary, probably.
I want to transition a bit into the financial model
of this business.
I think we've touched on a few of the dynamics with the top line
and whether that's flat because it's neutralized
by price and volume or maybe steady growth, slight incremental
growth in the future.
We hit on the tax that is very common on these businesses.
But just if you step back and look at the overall margin profile
of this business, what does that look like?
And where has that trended over time?
The margin profile of the business
is remarkably stable.
That's one of the nice things about these tobacco businesses.
On a gross margin basis, the company basically
has been making in 2013, they were at 78% gross margin.
And in 2024, it's going to be an 83% gross margin.
And in terms of operating margin, it's basically
been around 40% for a really long time.
That's one of the attractive things about these businesses
is that the margins are super stable.
Obviously, the customer base is coming back
sort of a daily consumption product.
And the combination is a business that just throws off cash
and can use that to pay dividends and buy back shares
and do all the rest.
One of the most commonly referenced things
with investors is the free cash flow yield.
Can you talk a little bit about earnings conversion
in terms of how much is actually dropping
through to free cash flow?
One of the great things about the tobacco businesses
is that they don't require a ton of capital to grow
or to sustain itself.
So with British American, this is a company
that did 9.2 billion of operating cash flow last year
and only required 500 million of cap X.
So what that means is basically all
of the 8 billion of income is falling to free cash flow.
And so what that does is it allows them to pay down debt
because they bought RJ Reynolds in 2017
and that's how they had 50 billion of debt.
So they've been slowly paying that down.
But then primarily, they pay a gigantic dividend.
So last year, they paid up 5 billion of dividends,
which on the stock price, I mean, for 50 billion market cap,
that's basically going to be a 10% yield this year.
And contrast to a lot of 10% yielding companies,
this is not like some oil driller that's paying you out
the last drops of profit before the futures curve collapses
or whatever.
This is what I think is probably going to be a stable
to slowly growing business that just has a 10% dividend yield.
Not a cigar, but.
Exactly.
Sure, it's not the first time that has.
I actually had not made that connection.
That's interesting.
I think it's a name that you often hear from investors
as screening attractive from a valuation standpoint.
They have the free cash flow yield.
There's been a steadiness in terms
of the actual earning stream as well.
But it hasn't quite responded to any of that.
So I think it gets this designation as a value trap.
Are there catalysts that you see that could unlock a change
in the actual perception of the stock
or investment of the stock or stock performance?
The first thing to understand is I think the valuation itself,
actually at this point in 2017, it traded at 15, 16, 17 times
earnings, the valuation can decline at that point.
But from six times earnings, six times free cash flow,
it's just a lot harder for it to decline, I think.
That's the first thing.
The second thing is that honestly, the dividends
and the growth in the dividend can just create
its own return at this point.
I don't necessarily agree with him on all that much,
but this is something that David Einhorn was talking about recently
and how he views some of the stocks he holds.
It's a great way to just have the downside protected
because you can just collect a 10% dividend
that's probably going to grow, in which case,
you're going to earn a double digit return and then some.
The biggest thing is as people start to realize
that these tobacco companies, they're not melting ice cubes
anymore because they have this business
which is going to replace all of the traditional tobacco
revenue that they're going to generate.
I mean, it's going to take years,
it's going to take 10 years to get to 50% of revenue
what's going to happen.
As they start to realize that and that it's going to be the case
for BAT, I think there's a good chance
that the stock could re-rate.
And then you're talking about taking a 10% plus return
into could be anything, just depends on what timeframe
you're talking about.
But if you look at Philip Morris,
I mean, Philip Morris trades for like 14 times,
and Philip Morris might even be cheap.
And Philip Morris trades for 14 times earnings.
I mean, if BAT traded for 14 times earnings,
it would have to more than double.
So that's kind of the third potential
as that as people kind of realize that
not only is it not a melting ice cube anymore,
it really shouldn't be viewed as such a negative ESG company,
full stop, traditional products do still kill people.
But there's something to be said for a company
where all of the future efforts are going towards switching
people off of that product and on to something
that's way less harmful.
And it's not because it's the goodness of their heart,
they're just trying to make money
and protect themselves for the long term.
But I think there's a chance that it results
in a change in perception in the market.
And then actually the fourth thing is
once reduced risk products really take off,
like we're seeing Zinn in the US,
the market overall may grow.
Because if these products are really 90 to 95
to whatever percent less harmful
than traditional cigarettes,
you're left with a drug that has some interesting properties
and might be just like caffeine
where like huge chunk of the people take it.
I mean, think about the fact that after World War II
in the US, 50% of people smoked in the UK,
80% of men smoked.
I don't necessarily know that I want to go back
to a world where 80% of people are taking nicotine,
but it's certainly plausible in my view
over a long enough period of time.
Yeah, there's a lot of interesting parallels
when you look at, as you mentioned, caffeine
to the other extent alcohol.
We have legalization of cannabis,
all different properties, all different addictive traits
in them, all different health concerns.
So there's other industries that you can look at,
but at least from my perspective,
it feels like these brands have the most negative
visceral association with them today.
In the UK, I don't know if it's done this survey in the US,
I think in the UK, 80% of people still think
that nicotine is the primary cancer health problem
causing agent in tobacco.
Just wait the fact that that's pretty settled science
that it's not the case.
Just from your sense of talking to other investors,
as you mentioned, whether it's ESG
or just funds out of principle not wanting
to own this type of product, do you have a sense
of how big that represents in the market?
Like how many buyers just have ruled themselves out?
What I think you find it, I mean,
just in the world in general, but especially investing,
is market prices are dominated by the largest players
how they feel.
And I think if you look at a lot of the largest investment
businesses in Europe, and certainly pension funds,
and everyone in Europe is really devoted to ESG,
and there's a lot of great causes behind ESG,
but I don't know if divesting tobacco
is gonna remain at the top of the ESG list in 10 to 15 years.
And I don't think it helps BAT, actually,
that its primary trading ticker is in London,
as opposed to Philip Morris,
where the primary trading ticker is in the US.
So it's kind of weird that the international business
trades in the US, that trades at 14 times earnings,
it's kind of an interesting dichotomy,
which can partly be explained by Philip Morris's,
how much further they are down the road
of the journey toward reduced risk products,
but I think part of it's probably also explained
by European investors like stronger focus on ESG
and related shunning of tobacco stocks.
One of the points on capital allocation,
which we didn't hit on, was the M&A activity,
which historically, there's been a lot of acquisitions.
I think there's something interesting about Zen being
an upstart, then being acquired, I think,
of parallels to something like cosmetics,
where L'Oreal and some of the bigger players
can buy up these upstarts that have this success
before they get too big, is that something
that you expect to continue in the future as part
of the thesis in one direction or to the other,
is M&A activity something that you expect to happen
on the horizon?
I don't, I do not.
I think that for the most part,
these companies have really gobbled up everything
that could really move the needle
and also be regulatory approves.
I think Philip Morris got an amazing deal
as it turns out with Swedish match.
They paid what was like a premium
to traditional tobacco multiples,
but really did not compensate them for the growth
that they were going to see in the Zen business.
I think they would pay many more multiples now.
They paid 22 times EBITDA,
but they were sitting on a rocket ship, basically.
I don't expect it to be a big part.
It's possible we could see upstarts.
It kind of revolves around the regulatory structure, honestly.
In a world where any type of disposable vape
can be sold on stores,
and there are, there are upstarts all the time,
there's brands changing left and right,
but in a world where you actually need FDA
or other regulatory, whatever country,
approval to sell a nicotine product,
which is the world I think we're moving towards slowly,
I think it's going to continue to be dominated
by the companies that have the money and the time
and the regulatory prowess to actually navigate that.
I think it's telling that views is one of the only
actually approved products in the US.
At this point, like the FDA is its own monster,
I don't think the FDA knows that its policies have over time.
I mean, it's not just the FDA, right?
It's like advertising bands and all these things.
I don't know if people really understand
how much it entrenched the existing tobacco companies
and kind of benefited them,
but it's just kind of part of the deal
with this level of regulation.
Yeah, regulatory capture in this way.
And when you think about other industries,
something like cannabis, which I mentioned before,
is there any possibility that there's an extension
into cannabis?
BAT has made, I think a couple hundred million pounds
investment into a Canadian, basically like almost penny stock now.
Canadian publicly traded cannabis company.
You can close your eyes and imagine a world
where the distribution and regulatory prowess and all that
allows them to add value to a cannabis company
and potentially like try to acquire one.
Any type of profitability in that business
seems likely to be a rounding error
on any of BIT's business.
I mean, it took decades for most of the cigarette brands
to kind of be developed.
And so I think probably cannabis might be similar,
but we'll see, I'm not holding my breath.
I think we've touched on most of the risks.
There's just the obvious industry in general
and trend lines that have been happening over a long time there.
Is there anything else we haven't touched on
that you think is important to know?
Yeah, there is actually the major risk
that we haven't touched on is the potential for
menthol cigarettes to get banned in the US.
So British American, when they bought Reynolds,
Reynolds had to divest the cool brand
of menthol cigarettes imperial
when they acquired lower-large,
but the Newport lower-large brand,
which is the largest, came in to British American's business
when they finally acquired our J-Rennels.
And to this day, menthol cigarettes in the US
are a huge percentage of their business.
It's like on the order of 40, 50% of the US
combustibles business and that means it's
around a quarter of their revenue.
Let's take a step back.
So the reason why that matters
is because the FDA under the Biden administration
has made a bunch of noise about banning menthol cigarettes
entirely across the US.
Now, this is a little bit controversial.
We definitely get caught up in a legal battle
for years if it did come to pass.
It's a big risk for them because we think that some consumers
would probably stick with their brand
in a non-menthol version,
but some consumers are gonna choose another brand,
some consumers are gonna quit smoking.
One upside could be that some consumers will choose
one of BAT's vaping brands
because they're the largest brand in the US,
so that would make sense.
But NetNet, we think that they could lose 10 to 15%
of their profits on a menthol ban in the US,
which is a lot of billion dollars basically of profit.
Now, I think at six times earnings
for a business that's otherwise gonna grow,
we think low single digits, that's baked in already.
And when you kind of multiply that
on an expected value basis by the percentage chance
that either Trump wins the election,
and I don't think they care about this,
or Biden decides not to do it for whatever reason.
I think it's a risk that's well baked into the price,
but it is a risk, definitely.
One thing you mentioned there, which I wanted to touch on
earlier was the vaping phenomenon,
which felt like it was really powerful,
by Vish maybe a little bit longer than that years ago,
but the craze seemed to have died down.
Now, I don't know if that's been reflected in the numbers
as well, but can you point to anything
just about that real euphoria run up around vaping?
I think because it was starting from nothing,
and the percentage change was just so huge
that it really kind of took the world by storm,
it was also under-regulated.
All of a sudden, Jewel was everywhere,
and they had all these flavors,
and kids are smoking it, and you can go watch
the Netflix documentary on Jewel,
and kids are talking about how they got addicted
in high school, and they didn't know
that it had nicotine in it.
They thought it was just air,
and that is so crazy to me now,
and I think probably high school kids are,
unfortunately, some of them are still vaping,
but I think they know kind of what's going on now.
But yeah, I think it was just such a big explosion
from nothing that it seemed like it reached the airwaves
and national news, et cetera, more quickly.
But since then, the industry has continued to grow.
The same chart that Altria put up,
you have a steady 16 billion pack equivalents in the US,
in the overall sort of nicotine market,
but you basically have the evaper,
the vapor market growing by 5X since 2018,
something like that, and 20 or 30% last year.
The problem is it's not all in channels that are well tracked,
so it's harder to keep track of,
whereas when it was just Jewel,
Altria was invested in Jewel,
we knew what was going on with Jewel,
but whereas with these Chinese companies selling
disposable, it's a little bit more under the radar
in terms of business news,
but it's still growing very strongly,
20 or 30% in the US.
Good example of where my perception
is not equivalent to reality there.
But this has been an excellent conversation.
We close these out with the lessons
that you can apply elsewhere.
What would you point to is just a lesson from diligence
on British American tobacco that you think
is cross applicable to other investment opportunities.
I think the biggest lesson I've learned
from studying British American tobacco
and investing in the company is to always look under the hood
and make sure you really understand
what's going on with the company,
because a business might be flat at 26 or 27 billion
of sales over a long period of time,
and it might have a lot of shareholders complaining
about why it's a value trap,
but under the hood,
a lot of people aren't paying attention to what's going on,
and if you peel back the layers,
then occasionally you can find a strong investment opportunity
that's not reflected in the current share price.
So the investing process is always a battle
between how much time to spend on a given name
and when to move on.
And I think the lesson is you have to spend enough time
to really figure out what's going on.
Good wisdom there, and I think completely appropriate.
This has been an excellent conversation, Evan.
Really appreciate you sharing the detailed history
and bringing us up to today,
with just as much detail about the recent years.
Thank you for coming on.
Thanks, Matt, appreciate it.
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