British American Tobacco: New FDA Ban on Vuse Alto Menthol Variants Means Little

Company Update (BATS LN) (Buy)

Highlights

• Courts will put a stay on FDA bans and may overturn them

• The key risk is still FDA’s plan to ban menthol cigarettes

• Retention in previous menthol bans ranged from 65% to 110%

• BAT would have a 10x P/E even if EPS is cut by 30%

• At 2,444.0p, we see 115% total return (30.7% p.a.) by 2026YE

Introduction

The FDA issued Marketing Denial Orders on 6 menthol and other flavour variants of Vuse Alto, British American Tobacco’s ("BAT") biggest Vapour product, on Thursday (October 12). BAT American Depository Receipts (“ADR”) fell by 4.8% in the subsequent 2 days, taking them to their lowest level since the COVID-19 trough in March 2020:

BAT Share Price Performance (Last 5 Years)

Source: Google Finance (13-Oct-23).

Excluding pandemic lows, the price of BAT’s ADR has not been this low since the 2008 Global Financial Crisis.

We believe the latest FDA bans were not a surprise and will be inconsequential. The FDA has consistently refused to authorize menthol and other flavoured Vapour products. BAT is challenging the bans in court and will receive a stay on their implementation. There are precedents of FDA bans being overturned. Even if the bans were to take effect, Vuse has recently demonstrated 100% volume retention in a similar ban in California. Menthol cigarettes, still available in most states and where BAT has a 50%+ share, will further help retention.

The key risk remains that the FDA will succeed in its ongoing plan to ban menthol cigarettes. Our base case is it will not; in any case it will be a multi-year process. Previous menthol bans have shown volume retention of 65%+ in the same category and up to 110% including other categories. The effect of a FDA menthol ban would likely be worse once Philip Morris (“PM”) starts selling IQOS Heated Tobacco in the U.S. IQOS has FDA authorization for menthol consumables for its blade version, and will likely receive the same for ILUMA, though not before 2025.

BAT is a “value” investment where we believe the probability of a major disaster is more than priced in. At 2,444p, BAT shares have a 6.5x P/E, a 14.7% Free Cash Flow Yield and a 9.4% Dividend Yield. A 2022-26 Adjusted EPS CAGR of 3.8% and a 10.0x exit P/E would more than double an investor’s money. BAT’s low valuation and leadership in Vapour also make it a hedge for Philip Morris against the main bear case of Vapour dominance. Buy.

FDA Bans Were Not a Surprise

The FDA bans against Vuse Alto’s menthol and other flavoured variants should not be a surprise to investors.

The agency has consistently issued Marketing Denial Orders (“MDOs”) against Pre-Market Tobacco Products Applications (“PMTAs”) filed for menthol or other flavoured Vapour products. Thus far it has issued MDOs for menthol variants of Vuse Vibe and Vuse Ciro (both in January 2023) as well as Vuse Solo (in March 2023), and for those of Imperial Brands’ myblu (July 2023) and Japan Tobacco’s Logic (October 2022). Including other flavours, the FDA has issued MDOs to 6,500 flavoured Vapour products as of May 2023. Conversely, tobacco is the only flavour that appears in any of the 23 FDA-authorized e-cigarette products at present.

The FDA press release announcing the MDOs for the Vuse Alto variants explained their rationale as follows:

“Evidence submitted by the applicant did not demonstrate that the menthol- and mixed berry-flavored products provided an added benefit for adults who smoke cigarettes—in terms of complete switching or significant smoking reduction—relative to that of tobacco-flavored products that is sufficient to outweigh the known risks to youth.”

In other words, the FDA does not dispute these Vapour products can help adult smokers to quit, but they suspect these products will also create enough new underage users such that the net effect on public health would be negative. It is up to PMTA applicants to provide sufficient evidence to prove this is not so, and the FDA believes BAT failed in this case. This is also the most common rationale used for the other MDOs listed above.

Similarly, when Altria agreed to purchase NJOY, the $2.75bn consideration was set with NJOY menthol products still lacking FDA authorizations. Altria has agreed separate earn-outs, worth up to $500m, in the event that these products were to receive Marketing Granted Orders – meaning Altria saw a strong likelihood that they would not.

Bans Will Be Stayed; May Be Overturned

Immediately after the FDA’s announcement, BAT stated it will be challenging the bans in court “immediately”.

BAT will likely receive an administrative stay on the MDOs from the U.S. Fifth Circuit Court of Appeals, just as it has immediately following the MDOs on Vibe, Ciro and Solo listed above.

There are precedents of FDA MDOs being overturned completely, including for menthol and other flavoured variants.

Turning Point Brands (“TPB”) received a MDO on its Vapour products in September 2021. TPB challenged this in court and quickly won in October 2021 when the FDA conceded that it “found relevant information that was not adequately assessed” and rescinded its MDO. The FDA started to review the PMTAs in question again, and the Vapour products concerned, including in menthol and other flavours, have stayed on the market to this day.

Imperial Brand’s (“IMB”) myblu (through its Fontem subsidiary) received FDA MDOs on both flavoured and unflavoured variants from April 2022 onwards. IMB challenged these in court, and a ruling by the U.S. D.C. Circuit Court of Appeals in August 2023 overturned the MDOs on unflavoured variants but confirmed those on flavoured variants:

“As to Fontem’s flavored products, the FDA reasonably found a lack of evidence that the benefits of such products to adult smokers sufficiently outweighed the potential risks to young non-smokers. As to Fontem’s unflavored products, however, the FDA acted unlawfully by failing to engage in the holistic public health analysis required by the statute. The agency did not take into account the potential benefits of unflavored products or weigh those benefits against risks to the public health.

Accordingly, we deny the petition for review as to Fontem’s flavored products and grant the petition for review with respect to the unflavored products.”

Note the court defined “unflavored” as “the same flavor as more traditional tobacco products – menthol or tobacco”.

The FDA may eventually issue new MDOs to TPB and/or appeal the court decision on IMB. However, these examples show the MDOs on Vuse Alto will be inconsequential in the near term, and have a good chance of being overturned.

Only 5-10% of BAT Profits Affected

We believe menthol and other-flavoured U.S. Vapour variants likely represent 5-10% of BAT’s Adjusted Profit from Operations (“PfO”, equivalent to EBIT).

BAT reported £520m of U.S. Vapour revenues in in H1 2023, or 9% of its U.S. revenues. The U.S. region in turn contributed 53% of group PfO for the period. We believe U.S. Vapour revenues appear to have similar margins to cigarette revenues (a recent BAT slide indicated U.S. Vapour margin was at 80-120% of cigarette margins).

BAT’s 2022 annual report stated 75% of Vuse consumables were in menthol variants (we think they meant in the U.S.; the figure was 60% in California). We do not know how much of the rest is in other flavours. Assuming a significant portion of revenues in tobacco variants, a lower margin than cigarettes but some negative cost absorption, we arrive at a 5-10% range as the likely contribution of menthol and other-flavoured U.S. Vapour variants to BAT group PfO.

Historical Menthol Ban Precedents

Even if a MDO against Vuse’s menthol products were to be implemented, we expect BAT to retain close to 100% of the volume.

Previous menthol bans have shown volume retention of 65%+ in the same categories, and up to 110% including other categories. Retention depends on what the product is, and what other products are available in the market from both BAT and competitors.

In California’s ban on all flavoured tobacco products (including menthol cigarettes and flavoured Vapour) implemented in November 2022, BAT estimated that it has retained 85% of its volume in cigarettes (net of a 13% category decline) and 100% of its volume in Vapour:

Volume Retention in California Flavours Ban (2022)

Source: BAT results presentation (H1 2023).

The retention figures quoted refer to retention for each category, including both menthol and non-menthol.  Menthol was 45% of BAT’s cigarette volume and 60% of its Vapour volume in California before the ban. These imply a retention of about 68% in menthol cigarettes (since they lost 15% of the 45%) and up to 100% in menthol Vapour. This was achieved with all other flavoured tobacco products also banned in the state.

We know from Philip Morris’s Q2 2023 results that their ZYN nicotine pouch sales in California suffered no lasting impact from the ban. As with Vuse, this shows that retention is likely to be higher for Reduced Risk Products.

In the European Union ban on menthol cigarettes in May 2020, BAT estimated that the industry has retained 91% of its menthol volume within cigarettes, while BAT has gained users in cigarettes as wells as in each New Category, with the net result being a 110% total retention across all nicotine categories. This was achieved with both BAT and competitors being able to market flavoured Vapour and Heated Tobacco products.

Volume Retention in E.U. & Turkey Menthol Cigarette Bans (2020)

Source: BAT results presentation (2020).

(Philip Morris’s IQOS had a moderate presence in the E.U. in 2020, with its share of the tobacco market flat at 3.9% through Q1 to Q3, but rising to 5.0% in Q4; this has risen to 9.0% as of Q2 2023.)

In the Canadian ban on menthol cigarettes (implemented by each province across 2016-18), BAT estimated that the industry has retained 99% of former menthol users within cigarettes. This was achieved with limited availability of other tobacco products, as the Vapour category was still in its infancy and Heated Tobacco presence was minimal.

The above show a lower retention of menthol cigarette volumes with each more recent example, which may not be a coincidence but the result of Reduced Risk Products providing increasingly attractive alternatives. However, for Reduced Risk Products, retention of menthol volumes can be up to 100%.

What retention would look like in the event of a ban on Vuse menthol products depends on the circumstances. The up to 100% figure demonstrated by Vuse in California is a good base case. With menthol cigarettes still available in most states, Vuse menthol users would likely return to menthol cigarettes (where BAT has a 50%+ share), just as FDA actions against Juul and non-menthol flavours in 2019 appeared to have driven many smokers back to cigarettes:

U.S. Industry Volumes, Vapour vs. Cigarette (2019)

Source: Altria results presentation (Q4 2019).

The combination of Vuse’s record after the California ban and the availability of BAT menthol cigarettes, offset by the availability of competitor flavoured Vapour products (which have not yet received MDOs) and menthol nicotine pouches, mean that we believe BAT’s overall retention of Vuse menthol volumes will likely be close to 100%.

With any delay in the implementation of the MDO, BAT’s ability to retain Vuse menthol volumes will likely increase because more competitor flavoured Vapour products will be taken off the market by the FDA over time. (This does not take the eventual arrival of IQOS in the U.S. into account.)

The real risk to BAT is thus not in a ban on menthol Vapour but one on menthol cigarettes.

Menthol Cigarettes Ban Still Key Risk

The bigger risk remains that the FDA will succeed in its ongoing plan to ban menthol cigarettes. Menthol cigarettes are roughly 60% of BAT U.S. cigarette sales, and they would help retain Vuse menthol volumes in the event of a ban.

The FDA announced its proposals to ban menthol cigarettes in April 2022, as the start of a long process. It had expected to publish the Final Rule in August 2023, but this has been delayed. As of September it stated it would complete work on the rule “in the coming months”, so we will likely see this by the end of the year.

BAT has consistently stressed that it expects FDA rulemaking to be a “multiyear, multistep” process. It has pointed out that FDA would need scientific evidence to justify any ban on menthol cigarettes. It has also indicated that it will challenge such a ban in court. Because of all of these, our base case is that the FDA will not succeed in banning menthol cigarettes; in any case it will be a multi-year process.

We believe a scenario where the FDA succeeds in implementing bans on both menthol cigarettes and BAT menthol Vapour products, even if it were to materialize, would be unlikely before 2025.

However, the impact of this scenario on BAT could be moderately worse after 2025, once Philip Morris starts selling IQOS Heated Tobacco in the U.S., including menthol variants.

Risk from IQOS Menthol Products

Philip Morris is set to start selling IQOS in the U.S. again in May 2024, after Altria has returned the rights as agreed. As we described in our recent article, PM’s plans for IQOS in the U.S. are intentionally gradual, with the initial launch limited to 4 cities in 2 states and the “national roll-out” of 10 states across 12 months likely to happen only in 2025 (after the expected authorization of IQOS ILUMA, for which PM will submit a PMTA this month.)

IQOS could be a threat to BAT’s retention of menthol customers, particularly because it will include two menthol variants, Smooth Menthol Heatsticks and Fresh Menthol Heatsticks, authorised by the FDA back in April 2019. The authorizations are for the original blade version of IQOS, and PM will have to file new PMTAs for the ILUMA version, but we believe that these will also be authorized. (Unlike Vapour, Heated Tobacco has much lower youth usage risks and so can more easily demonstrate a net benefit to public health.)

BAT’s difficulty is that Vapour currently represents its only viable Reduced Risk Product in the U.S.

• In Nicotine Pouches, the category share of its Velo products has collapsed to 1.3% in the U.S. as of H1 2023, while the category is dominated by PM’s ZYN and, as a distant #2, Altria’s On! – both with menthol variants (in most states)

• Its Heated Tobacco product, glo, does not have a FDA authorization at present, though it is possible this will be granted soon (given a PMTA was submitted for glo Hyper in December 2021).

In the event of a menthol cigarettes ban, BAT may have to try to retain customers with no meaningful menthol Reduced Risk Products of its own while the best ones on the market are offered by its competitors. This would reduce its retention of menthol volumes, potentially to even lower than the 68% demonstrated in California.

BAT Valuation: Disaster Priced In

We have a Buy rating on BAT as a “value” investment where the probability of a major disaster is more than priced in.

At 2,444p, BAT shares have a 6.5x P/E and a 14.7% Free Cash Flow (“FCF”) Yield:

BAT Net Income, Cashflow & Valuation (2019-22)

Source: BAT company filings.

The dividend is 230.9p, which represented a Dividend Yield of 9.4%. The Payout Ratio is just 62%. Management targets a “65% Dividend Payout Ratio over the long term and growth in sterling terms” (reiterated on the H1 2023 call).

BAT has already reduced its Net Debt / EBITDA to 2.6x by H1 2023 (down from 2.89x at 2022 year-end; target is the middle of a 2-3x range). Adjusted Net Debt was £37.3bn, which means BAT can reduce it by ~0.2x (and Net Debt by ~8%) annually through repayments alone (given the ~£3bn of FCF left after dividends).

BATS’s valuation is exceptionally attractive provided earnings do not actually decline, and our expectations remain that BAT will see EPS growth in the medium term, with cigarette price increases more than offsetting volume declines, IQOS not having a meaningful impact in the U.S. until after 2025, and only moderate negative operational leverage.

Net Finance Costs were ~13% of Adjusted PfO in 2022, which means the effect of any negative financial leverage would be moderate, with a 30% reduction in Adjusted PfO only producing a 34% reduction in Adjusted EPS:

Hypothetical BAT Adjusted EPS Downside (2022)

NB. Excludes higher tax rate, lower finance costs & lower share count in 2023. Source: Librarian Capital estimates.

A 30% reduction in BAT’s Group PfO is an extreme downside case, comparable to the 30% decline in Adjusted EBIT in Japan Tobacco’s (“JT”) domestic tobacco business in 2016-21, from a combination of IQOS disruption and “investments” in JT’s own Reduced Risk Products. (JT stopped reporting standalone domestic tobacco P&L figures in 2022.) However, even relative to the Adjusted EPS in this hypothetical scenario, BAT shares have a P/E of just 10x.

Other Reasons to Buy BAT

Near-term catalysts for BAT shares can include a FDA authorization of tobacco/unflavoured variants of Vuse Alto (originally expected by year-end), and a deceleration in U.S. cigarette volume declines from both moderating inflation and easier prior-year comparators.

In addition, we also see BAT as a potential hedge for our much bigger PM holding, because BAT would benefit from one of the two main bear cases for PM, where Vapour (where BAT leads) comes to dominate Reduced Risk Products and cannibalize Heated Tobacco and Nicotine Pouch sales. (The other bear case is a change in regulations.)

BAT Stock Forecasts

We reduce our growth assumptions for BAT after 2023. Our assumptions are now:

• 2023 Net Income growth of 3.0% (unchanged)

• From 2024, Net Income growth of 1.0% (was 3.0%)

• No share buybacks in 2023 (unchanged)

• From 2024, share count to fall by 3% annually

• Dividends to grow with EPS on a Payout Ratio of 65% (unchanged)

• 2026 P/E at 10x P/E (unchanged)

Our 2026 EPS forecast is 431.9p, 6% lower than before (458.0p), and implies a 2022-26 EPS CAGR of 3.8%:

Illustrative BAT Return Forecasts

Source: Librarian Capital estimates.

With shares at 2,444.0p, our forecasts indicate a total return of 115% (30.7% annualized) by 2026 year-end. The re-rating back to a 10x P/E drive 60 ppt of the total return, dividends contribute 38 ppt and growth contributed 16 ppt.

We reiterate our Buy rating on BAT stock.

Ends

Stocks mentioned: PM 0.00%↑ MO 0.00%↑ BTI 0.00%↑ IMB. We are long PM and BAT.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.