One the most heavily watched and discussed stocks last week was British American Tobacco after it released a trading update. While the headline read relatively okay-ish, on the following pages they admitted to take a hefty 25 bn. GBP impairment on their US operations with the next earnings. While many see this as a non-event due to not affecting cash flows, I’m looking at it differently. I rather feel confirmed with what I wrote earlier in the year about Altria.
Summary and key takeaways from today’s Weekly
– It seems as if every new negative development and stock price decline of tobacco stocks is presented as nothing to worry about, but to load up.
– I clearly have a different perspective on that.
– At best, I see a low-upside, but overall-risky scenario, while valuations are rather fair, but not rock-bottom to try a last puff.
In February this year, I published an article mainly dedicated to Altria (ISIN: US02209S1033, Ticker: MO; see here) with a few side notes about some of its peers.
Altria is hated for the sin products it sells, but its stock is loved by many for its dividend at the same time. For more than 50 years straight, Altria managed to increase its dividend at least once yearly, giving it the almost holy status of a dividend king.
However, it is no secret that Altria has been struggling as of late (operationally and its stock) with its shares having peaked already more than five years ago. Loyalists continue to hold the stock for its dividend – no matter what, because of its great past.
Being in the red, at times deeply, is seen as fiction, because the dividend still flows.
My stance was that the time is ticking for Altria and that we’re likely approaching a point where the downfall picks up speed.
The main reason for this often criticized view was and still is that tobacco volumes have reached a point where price hikes become harder and harder – just to keep sales stable. We are not talking about growth. Not to mention that Altria even failed to keep sales stable in an inflationary environment.
Now, last week, British American Tobacco (ISIN: GB0002875804, Ticker: BATS) entered the stage and negatively surprised its stockholders and those still living in the past with a gigantic write-down on its US assets. The majority was definitely caught on the wrong foot, otherwise the stock would not have tanked by 10% on the day of the announcement. It even continueD to fall thereafter.
But slogans of perseverance were quickly thrown around.
This was clearly not priced in.
I even add on top: further declines or an acceleration are also not priced in!
While pundits claim different things like that the write-down will save them taxes through tax-loss carryforwards, that the dividend is easily covered by free cash flows, that they have already been dealing with falling volumes for decades or that the price is simply too cheap to be ignored and worth the risk – I completely disagree.
The dividend has been “juicy” and the stock “a great buying opportunity” already for years according to them. Those people live in self-deception.
What worked over the last say 20–25 years, will not work anymore.
The risks and bitter reality are played down too much for my taste and indeed there are too many risks. As my long-time readers know, I define risk as ignorance of not knowing what one is doing, referring to blindly buying any stocks, just based on hope or what happened in the past.
In today’s weekly, I am going to explain why I think that classical tobacco stocks have slowly finished and are unlikely to stage a comeback. Many of the darlings have been underperforming for a reason. I view BAT’s huge impairment as a warning shot that should be heard and taken seriously.
And no, we are not even seeing cheap, rock-bottom prices for a last puff.
The average total return of my best stock ideas is +14.0%, easily beating the S&P500 and the iShares MSCI World ETF.
as per 13 December 2023 market close
If you struggle to find high-quality stock ideas, let me inspire you. As a Premium or Premium PLUS Member, you receive my exclusive research reports with my best and market-beating stock ideas.
What I read from BAT’s announcement
First of all, to be frank, it is of course correct that the asset impairment of 25 bn. GBP has no ramifications on cash flows, as it is a non-cash accounting procedure.
So right, so good.
BAT’s CEO more or less described it as accounting history catching up with reality or something like this. This is correct. What he means by that is the cash has already been spent in the past, namely at the time of the almost 50 bn. USD acquisition of the remaining equity BAT was not already holding of Reynolds American in cash and stock in 2017 (see here).
What is now technically happening, without boring you with too many details, is that the carried value of the acquired assets on the balance sheet can no longer be justified.
Hence the impairment or write-down to adjust the value to reality.
Basically this means that the former expectations about future cash flows do not hold up anymore. Assets are there to operate a business. If the business does not run like expected and an improvement is not expected, the assets are obviously worth less in case of a mismatch between accounted numbers and financial modeling for the future.
And this is also why I shake my head when people claim that this is a non-event and even positive for a variety of reasons.
Maybe some of my readers can explain it to me, how can something be positive when you are expecting lower cash flows in the future?
What comes on top is that with this move management is forced to admit that they grossly overpaid for Reynolds, even though a different team was responsible for that.
source: TIKR
Does anyone seriously think that it is just a coincidence that BAT reached a new 13-year low and Altria is sitting where it was in 2014?
Of course, one can claim that it is due to ESG and fund managers not allowed to buy these stocks on a grand scale, if at all, to be green and clean.
But why are many met coal stocks near their all-time highs, then?
I am reluctant to accept that the market has it wrong. It is more likely that those evangelists who are reluctant to admit a mistake are wrong.
BAT’s American business accounted for slightly more than half of the operating profit per the latest half-yer results. It was just a question of time until such an impairment would be necessary, because volumes in the USA are melting down in the double digits. Minus 12.4% as of the half-year numbers, to be more precise.
It will be interesting to see what Altria and BAT will report volume-wise in the next quarter.
And no, price hikes were not enough, or were only enough to roughly hold sales stable on a currency neutral basis. BAT reported –0.2% sales and Altria even a worrisome decline of –3.7% in Q3 in its smokeable division (–1.4% for the first nine months) after price hikes.
source: BAT half-year 2023 earnings release (see here)
This is even more remarkable in the context of an inflationary environment where consumer staples companies massively jack up prices and thus are able to increase sales (not necessarily profits due to higher costs and margin pressure).
But Big Tobacco failed in this discipline miserably.
It was also reported that consumers are switching to cheaper brands due to inflation. Ironically, Altria even suffered the biggest volume decline in its discount segment.
To explain why price hikes are becoming a dull weapon, you need to understand the mathematics behind it. In a different context, I wrote about limiting losses to stay in the game, because the bigger they become, the disproportionately harder it gets just to get back to zero.
And this is exactly what applies here.
Have a look at the following table with a few examples:
| drop in percent | gain necessary to break even |
| –5% | +5.3% |
| –10% | +11.1% |
| –20% | +25% |
| –25% | +33.3% |
| –33% | +50% |
| –50% | +100% |
| –66% | +200% |
| –90% | +900% |
It is up to you to define where your personal sweat spot lies.
But I think that somewhere between 20–25% should be it.
In the last ten years between 2012–2022, Altria lost with Marlboro 35% of its volume (other premium and discount lost even more). As sales are around 15% higher now than in 2012, it seems that higher prices were able to offset the decline in sold packs.
But the last reported results show first cracks in this strategy.
The more so, as the pace of the suffered volume losses has increased dramatically. At current numbers, in just three years they could achieve what took them priorly a decade in terms of lost volumes.
Do you think it is realistic to hike prices by another 50% in three years?
The same applies to BAT of course.
Then we have a few other aspects to look at to make the story complete, as people are creative in finding other reasons to justify their losses bad investments:
- it worked in the past
- alternatives growing and finally replacing tobacco sticks
- alternatives having higher margins
- emerging markets with growing smoking rates
- other risks not mentioned often
- everything being priced in
I just want to comment briefly on each point:
it worked in the past: true, but volumes were dramatically higher, making it easier to hike prices. In effect, tobacco was even a growth sector until a few years, because price hikes together with operating efficiencies led to higher margins, thus turbocharging the bottom line.
Also, tobacco companies had far less debt on their balance sheets.
alternatives growing and finally replacing tobacco sticks: this is wishful thinking.
Altria completely failed with its Juul acquisition of almost 13 bn. USD (already completely written down and it was not even a complete ownership) and has nothing else in its tank with a leading and meaningfully contributing position.
At least nothing that could bring some tailwinds, not even in the mid-term.
BAT is strong with vaping and with oral tobacco / nicotine in some markets, but management said with the current announcement that they want to be a majority-smoke free company only by 2035, i.e. in twelve years. Until then a lot of the cigarette business will have been burnt down.
The fact that they claim to have reached break-even profitability (i.e. no more losses) could rather be due to cost savings or less marketing expenses, hence I’d be cautious here.
alternatives having higher margins: this is the carrot that management teams are presenting their hungry crowds. But one thing gets forgotten. The new products need lots of marketing (as long as it is allowed) to make the people familiar with the exploding choices of different alternatives.
With cigarettes, there were only the brands. Now, it is brands and different products where the names are not that well known. You will know that Marlboro is Altria in the USA. But who is behind Vuse, glo, Veev, Iluma, velo, on!, zone X, (my)blue or pulze – just to name a few? IQOS and ZYN might be known, but none of them belongs to BAT or Altria.
Realistically, marketing costs will for a long time not allow for higher operating or bottom line margins. Gross margins are fine, but not enough.
emerging markets with growing smoking rates: emerging markets usually have lower purchasing power and hence I doubt that margins will be even close to where they are in the Western world. Currently, they clearly aren’t. And there’s always the risk of massive tax hikes like in Indonesia or Pakistan – two countries with among the highest populations in the world – which sabotages this equation.
other risks not mentioned often: no one is talking about a menthol ban in the USA. However, this is exactly where BAT is strong due to Reynolds. Although it seems that it will be delayed after the presidential election, the FDA and politicians have increased the frequency of discussing this topic.
And by the way, the topic of flavored e-cigarettes is also on the table.
last point:
everything being priced in: pundits love to use the PE ratio or some EBITDA figure to show that valuations are low. My readers know that I dislike both – PE does not take into account debt and growth and the EV / EBITDA sounds nice and looks low, but it does not handle cash flows and investments into the business, not to mention debt servicing costs or taxes.
The dividend of course is also used frequently to point towards an undervaluation.
I do not comment on that…
BAT has currently an EV / FCF (my favorite metric) of c. 9x and Altria of 11–12x.
I view figures of 10x as having priced in neither growth, nor a decline. This is a good rule of thumb, based on personal observations, but also from what I read elsewhere.
One can say that BAT is now priced for a slow decline, Altria even for some small growth. The latter can certainly be excluded as of now. BAT is debatable. But I view the menthol risks as well as the emerging markets exposure as a negative, justifying the lower multiple. Plus, BAT has more debt on an absolute, but also relative basis than Altria.
Another, though more soft sign, for me is that the crowd of dividend and garbage hunters calls out every dip as a new opportunity to load up. Until they do not throw in the towel, I will not hurry to get active, neither personally, nor with a research report for my members.
I clearly have difficulties in finding a compelling upside scenario. These companies are swimming against the getting-stronger tide, while the hopes are what they are – hopes. However, I want clear low-downside, but decent-upside scenarios which I do not see.
By the way, Daniel and I discussed this topic (in German language) on Daniel’s YouTube channel last week.
If you’re interested in more compelling ideas – low downside and decent to high upside – I urge you to think about a membership.
My last research report was about a luxury company which at the time of publishing traded for a ridiculous EV / FCF multiple of around 10x, only – as a high-margin luxury company with a serious chance for a takeover bid at a high premium.
Conclusion
It seems as if every new negative development and stock price decline of tobacco stocks is presented as nothing to worry about, but to load up.
I clearly have a different perspective on that.
At best, I see a low-upside, but overall-risky scenario, while valuations are rather fair, but not rock-bottom to try a last puff.
If you’re looking for market-beating stock ideas that are checked for quality and indeed have attractive valuations, then my memberships could be of interest to you.
My picks on average achieved so far way higher returns than the benchmarks.