Chit Chat Stocks - British American Tobacco and The Past, Present, and Future of the Nicotine Industry With Devin LaSarre

Episode Date: September 9, 2022

British American Tobacco provides tobacco and nicotine products to consumers worldwide. The company operates under different brands including popular names such as Lucky Strike, Camel, Natural American Spirit, and Modern Oral brands. Listen as Brett and Ryan ask Devin questions about the company, its business model, and valuation. Enjoy the show! ***************************** This episode is sponsored by Quartr, the new way of doing company research. Access conference calls, presentations, transcripts, and more for FREE on your mobile device. Download Quartr on the App Store here: https://apps.apple.com/us/app/quartr-investor-relations/id1552412128 Download Quartr on the Google Play Store here: https://play.google.com/store/apps/details?id=se.quartr.android ****************************** This episode is sponsored by Stream by AlphaSense, the highest quality expert network library. Sign-up here and get a 14-day free trial:  https://streamrg.co/CCM ****************************** Access our “Not So Deep Dive” episodes by signing up for CCM+. Sign-up directly through Spotify or Apple Podcasts. If you listen on another podcast player, use this link and create a private RSS feed: https://anchor.fm/chitchatmoney/subscribe Need more information? Check-out our launch newsletter: https://chitchatmoney.substack.com/p/welcome-to-chit-chat-money-plus ****************************** Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Interested to see more of Devin's work? Follow him on Twitter here: https://twitter.com/DevinLaSarre?s=20&t=8A1z1Kf9_AQJ7FW1hFP9dw Contact us: [e-mail] Timestamps Industry | (4:05) British American Tobacco | (14:51) Business Segments | (24:10) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's episode is brought to you by our friends at Quarter. Quarter is an all-in-one investor relations app that provides frictionless access to conference calls, investor presentations, transcripts, and more, with Quarter investors can keep up to date with all their companies while on the move. I personally use it every earning season so that I can keep up with my portfolio companies while I'm on my commute to the office. They also just released a cool new feature that allows users to search across all transcripts. That means you can search and see how many companies mention terms like inflation or

cost pressure or recession or even metaverse, you name it. And the best part of all, the app's 100% free and it's on both iOS and Android. So go find it on your app store by searching quarter. That's Q-U-A-R-T-R, no E. That's quarter, Q-U-A-R-T-R. Welcome to Chit Chat Money. This is our typically Thursday deep dive interview, but we had a little scheduling mishap. So this is coming out on our Friday and our deep dive interviews we interview one analyst on a single stock and today we're talking with devin lasar and we're talking about british american tobacco and really the the tobacco industry generally he goes through a great overview of uh i guess the past present and potentially where he thinks the

future will be for the industry and so and then specifically hitting british american tobacco uh i guess if anyone's interested tickers bats or bti in the united states so we hit like yeah we hit the general and then any specific stuff with bti any big highlights from the interview yeah i mean i guess should we say what british american tobacco owns because we don't maybe that's a good overview they own camel or why don't you load that up while i talk about my favorite part i i like talking about the non-combustibles which is non-cigarettes uh they they own you know substantial stuff in vaping and nicotine pouches and that category has been growing really, really quickly as former Swedish match shareholders. It kind of hurt my heart listening

to that because the bull case I think is quite compelling. So listening to that was fascinating as well as their capital allocation strategy and what things could look like if the non-combustibles kind of start becoming a bigger part of the business as it might look like through maybe the 2025 2030 period and how that could stabilize um any of the volume declines and also keep you know revenue and profits uh grown at a steady clip yep and so in terms of brands they own lucky strike newport american spirit camel they own grizzly as well and then they've got some newer age products i guess you could say in glow velo and views um and then i guess before we let you guys get to the interview, I'll also mention that there was a bit of a background sound with

Devin's cat. If you hear that rattling... We've tried to edit it out at this point, but if you hear the rattling, yeah. Just think of, and you get annoyed by it, just think and laugh that it was his cat doing something. So, yeah. Yeah. It was a bit out of his control, but I think that's all we have for the intro. Without further ado, here's the interview. Welcome to Chit Chat Money. On this show, hosts Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital,

and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. All right, welcome in. Today, we are joined by Devin Lassar. He is the author of Invariant, which is a, you know, if you just look up Invariant Substack or you look up Devin Lassar's name, I'm sure you will find it. And we connected through Twitter and you had, I think we probably connected or at least you and brett did through shared interest in tobacco stocks so kind of what how did you end up covering the industry what kind of interests you about it yeah um

so i i fell into covering the tobacco and nicotine industry kind of by accident And I first started researching the industry heavily in 2010. This was on the back end of the GFC. And I'm not sure how well you guys remember the GFC, but even in 2010, there was a tremendous amount of uncertainty in the world. There were still a lot of open wounds. And I think anyone that claims that they were confident that they knew the trajectory of the world, you know, they were kind of full of it, you know, claiming that. And so I was running screens, came across, just digging into the tobacco names, and the numbers I saw simply weren't lining up with the narrative I had already built in my own head. In my life, I knew that the number of smokers were decreasing each year, volumes were going down, there was all this regulation.

I assumed that these companies were kind of going the way of the dodo. And yet when I combed through the numbers and I really started to put all the pieces together, I saw a story that was exactly the opposite. And so I'm like, all right, I got to understand if I'm seeing this wrong or what I'm missing or, you know, how does this make sense? so I do what I always do which is you know I go and buy a bunch of books and start reading about history and try to make sense of it but for my own portfolio I liked it just because you look at the industry and there's a tremendous amount of inelastic demand and so there's no cyclicality you have pricing power you're acting as a hedge against inflation and just kind of a pillar of strength during times of uncertainty if you look throughout history

and and so i didn't know exactly where it would lead me in term terms of focusing on it but i knew it needed to be part of my personal portfolio for what my goals were that makes total sense you told you researched excuse me the history of the nicotine industry for a long time, like you said, 10 plus years. What I guess, it's a long run, you know, everyone knows the big stories. It's been decades and decades of different things, regulation, scientific studies, different trends. What has led the industry to be where it is today? And then what is on the horizon for the future? And then after that, you know, we'll lead into British American tobacco. Great. Yeah. So I think people are familiar, at least with the recent history,

maybe the last few decades but the true history of tobacco goes back much further um there there's data showing showing usage going back thousands of years but what's interesting is that it didn't really make its way around the world tobacco that is um until really the last several hundred years where in in the late 15th century europeans came across it for the first time when they came to the americas but they saw the natives using it they saw it as this kind of bizarre habit they thought it was just unsophisticated something only you know a quote-unquote savage would do and it's bizarre to have smoke coming out of your your mouth and nostrils and it was kind of rejected initially but then you know some europeans started to try it they go oh yeah

kind of like this and and and then they brought it back to europe and it just proliferated and And you saw the 16th century, it started to grow a little bit. Then the 17th century, it just completely took off all around the world. And you had all these rulers, even these monarchs who are trying to control their population. They're realizing that tobacco is maybe starting to get more control than they have over the population. And so they're trying to outlaw it, and they're even outlawing it by threatening death to their populations.

And that's not stopping people from smoking or using snuff or what have you. And so ultimately what happened is these countries just largely accepted that, well, tobacco is here. It's wildly profitable. We may as well try to monetize it as much as possible and use it to our benefit. And it's wild, in the 18th century, we saw it ultimately leading to the war of independence for the United States, right? You have this, the Boston Tea Party, which really wasn't about tea, it's more about tobacco, and how tobacco is being taxed and the indebtedness that the colonists are facing from Britain.

But again, it seemingly has just been unstoppable and leading to more recent times. What we're maybe more familiar with in our history is you have James Buchanan Duke. And, you know, late 19th century, he starts using the first automated cigarette manufacturing machine. It increases production like a thousand percent. He starts supplying 40% of cigarettes in the United States, makes an outrageous amount of money, consolidates all the manufacturing in the U.S. into the American Tobacco Company. He decides he wants to take over the rest of the world, starting with the market in Britain, goes over there. imperial tobacco which was the leading company there kind of retaliates he goes well we're going to go for the u.s market so they're going back and forth realize you know what

makes a lot more sense for us to team up so what they do is they decide okay american tobacco gets the united states imperial gets britain and we're going to team up we're going to create a joint venture to take over the rest of the world we're going to name it british american tobacco right they were very uh they were very very creative with the man yeah they were very innovative back then every company i know we've looked at that period once and it's all americans u.s steel uh american tobacco british american tobacco right uh right to the point with the nats um and ultimately what ended up happening was the u.s supreme court looked at American Tobacco Company and said, yeah, this, you know, you guys are breaking all kinds of

antitrust issues. We got to split you up. So they split them up into four companies, American Tobacco, Ligon Myers, Reynolds, and Lorelei. And ultimately chopped up a little bit more American Tobacco got split up. And then Duke was left controlling British American tobacco. And that kind of takes us into more recently, maybe the history people are more familiar with, including, you know, say the last 70 years, where people really began to understand the health risks of cigarettes. And because of that, regulation started to become much more stringent we started seeing health warnings on packages restrictions on advertising smoking started to get banned in certain places like like on

plane travel and then of course there's the most well-known regulation which was the 1998 master settlement agreement which was seen at the time seen as crippling, where it looked at the original participating manufacturers, which was Philip Morris USA, Reynolds, Ronald Williamson, and Lorlard said, hey, you have to make huge payments forever. And also, by the way, we're completely restricting your advertising, your promotional work, and all your marketing efforts. And if you go back and you read headlines from right then, everyone was just hyper bearish on these names.

They said, there's no way these companies are surviving this. There's just no way. And of course, the exact opposite happened. because when there's no advertising and marketing, it makes it impossible for new competitors to enter the market. So these guys get to keep their market share. Since none of them are allowed to advertise,

they get to cut their advertising budgets basically entirely. So now they're sitting on all this extra money and they go, well, okay, I guess we can start doing buybacks and upping our dividend end and we'll start consolidating, which is exactly what they did. And since that point, we've seen basically everything that was split up from American

tobacco company reconsolidated. Now the space globally is an oligopoly. And there's a very short list of players that basically dominate the industry on a global level. And so that's kind of where we were just in recent history. This episode is brought to you by Stream by AlphaSense. Stream is an expert interview transcript library with more than 10,000 interviews spanning across all industries, including tech, media, consumer goods, and plenty more. Not to mention 70% of these experts can be found only exclusively on stream.

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I want to ask you, too, about the kind of where you think the future will go. But I think maybe save that towards some of the. Yeah, I think we got to. Yeah, well, maybe, yeah, say that for the end. Let's talk about British American tobacco specifically, which you kind of alluded to. Do you want to talk maybe about the what their segments are today? I think if there's anything else in terms of the history that you think is relevant, maybe touch on that as well. Sure. Yeah, I mean, it's been interesting to follow them and it's more fascinating to read about the entire history. They've been around much longer than I have, obviously.

The trends in combustible volumes is something I think most people are completely familiar with. They know that, you know, at least in the U.S., smoking kind of peaked in the 50s volumes, started to decline in the 60s, and it's been in secular decline ever since. And we can, again, look at, you know, health considerations, more health conscientious consumer, regulation, increased taxes, all these things impact that to varying degrees. um nonetheless that really hasn't stopped british american tobacco or the the industry as a whole from making more and more money and it really comes down to pricing power again there's a tremendous amount of inelastic demand for for cigarettes right and when you step back and you and you think about it from a fundamental level, it's important to ask something in my mind as simple as like,

what would the perfect product look like? And, you know, if I were to answer that, it would be something very, very straightforward, something that's really easy for me to make something that is really cheap for me to make something that has a lot of perpetual demand and something where I can charge a substantial premium so my margin's really fat. That sounds perfect. But obviously, economics 101 tells us that if you have that, competition

is going to swoop in and undercut you. And without something more distinct as a competitive advantage, that's a race to the bottom. And excess profits get competed away until you're average at best and potentially mediocre a lot of the times. Whereas when we look, again, with regulation insulating these incumbents, there is no new competition. So each year volumes decline, they raise prices, and something happens under the hood that I think goes unappreciated by most people. It doesn't just offset volume declines or hasn't historically.

it actually makes ongoing operations incrementally more profitable. Obviously, if you are shipping or producing less, you have less associated costs with production. But also, stepping back further, you have to realize that for cigarettes, globally, the average pack of cigarettes, 50% of the retail price is taxes. And so when you are shipping fewer units, you are paying fewer taxes. But if you're raising your prices, you're keeping a larger total share of that retail value, right? So if you look historically, especially for for something like like altria simply because that's a good example simply because they operate in a single market in the united states most of their revenues is you know combustible cigarettes

they have the number one most premium brand and if you look historically their operating income goes up and to the right despite volumes going you know down into the right and their operating margins like clockwork just keep expanding expanding expanding and it's done so you know like clockwork and i i think that the the major manufacturers of the world can likely continue to to kind of maintain that dynamic for a considerable period of time going into the future if you look at affordability rates u.s most lucrative market in the world still very affordable lots of markets very affordable emerging markets as discretionary spending goes up affordability kind of increases or at least levels out you also see these companies

is leveraging analytics, where they can very precisely manage production, distribution, they can assess sales, and they can adjust accordingly. And it's gotten to the point where they basically have masterfully optimized their working capital, where it's truly, in my the epitome of a well-oiled machine well-oiled machine and if you if you look at the the metrics of the these companies it's just absolutely on how lucrative they are if you look at their margins on every level if you look at return on net tangible assets again you for for their core operations they need very little to to generate a whole lot of of profit kind of year in and year out right one follow-up here specifically with bti

what um and bti is just oh that's the shorthand for the ticker i guess bats or british american tobacco if i if you catch me saying bti that is british american tobacco that is the ticker in the United States. What's their geographical overview? Because I know they're pretty international. But just I know that's kind of important, because some areas are have, you know, slower declining volumes than others. And do you think that's really important for the for British American tobacco in general? Great question. And yes, absolutely critical. So, you know, I've, I focus on the major manufacturers and of the of the three largest philip morris international ultra and british american tobacco they all kind of have unique

geographic distributions for operations and i i think bat is incredibly well positioned ultra operates just in the u.s which is fine it's the most lucrative market in the world And especially recently with the U.S. dollar appreciating, certainly seems to be going well. You look at PM, they operate everywhere outside of the U.S. and ex-China. Because in China, basically, CNTC is the government-owned monopoly, right? So there's no access to that. And the issue with PMI is not being in the U.S., but reporting earnings in U.S. dollars can be rather problematic in terms of foreign exchange dynamics, currency dynamics, right? British American tobacco, on the other hand, overlaps the two.

They acquired Reynolds in 2017, which gave them a big chunk of the U.S. market. And so right now, about 55% of their operating profit is from the U.S., a big chunk in Europe, and then throughout the rest of the world, they derive the rest of their revenue sales operating profit. But again, very strongly geographically diversified, which I think is incredibly important when you're just trying to take a truly longer term view on the net. If you're listening to this ad right now, we know you're already a listener to our show. But for our avid listeners, we've also started a paid membership service called Chitchat Money Plus that extends beyond just our podcast. Every Tuesday, subscribers get access to one not-so-deep-dive research episode that covers everything you need to know about a company. You also get an email newsletter with our written show notes, important charts, a transcript of each show, and access to our Chit Chat Money research files. Chit Chat Money Plus costs $5 a month.

You can subscribe directly through Spotify or Apple Podcasts, or if you listen on another platform, click the link in the show notes to go through the simple steps of signing up. If you're a regular listener to the show, we think the membership will provide tons of additional value. On top of the stock research episodes, members will get one Arch Capital Fund episode a month where we outline why we bought, sold, or continue to hold a stock in the Arch Capital Investment Fund, along with shows on our broader investment strategy. Sign up and become a Chit Chat Money Plus subscriber today. We can't wait for you to join our community. All right, Ryan, you had non-combustibles? Yeah, I guess do you want to maybe mention what difference, for anyone that isn't familiar with British American tobacco, what the different segments are of their business? Because what the combustibles are, what the non-combustibles are, that kind of thing. Sure, yes.

So combustibles, pretty straightforward. I mean, let's just really just call it cigarettes. There's also roll your own and make your own other tobacco products. But one that's overall really a negligible part of the business. Also, it's in a very strong secular decline where I don't really factor it into how I think of the future prospects of the company. And so combustibles, I equate with cigarettes. And then you have non-combustibles, which is really four things. Firstly, there's traditional oral, like snus, and then there's these new categories, the next-gen products, which you have vaping, you have heated tobacco products, then you have modern oral.

And the three of those are what I, you know, aside from cigarettes, and cigarettes are still the bulk of the company's sales and profits, the new categories are what I focus on simply because I think that they are very misunderstood. And I think that there's a lot of potential for not just British American tobacco, but for the industry as a whole. And I believe that potential is being largely discounted, broadly speaking. So you have vaping, which generally, to simplify it, uses a synthetic nicotine liquid. generally can use some kind of flavoring you're vaporizing it inhaling heated tobacco uses specifically fabricated tobacco plugs that it then heats but does not burn because you're heating you're aerosolizing uh a vapor able to inhale that but you're not burning it and you have modern oral which uh you know the most recent products are the tnfps which are

tobacco-free nicotine pouches with that it's extracted nicotine flavorings water uh like a cellulose pouch or similar fabric pouch and again um the fact that none of these are actually combusting. None of them are burning like a cigarette. Science seems to show that the exposure to harmful or potentially harmful chemicals from these products is substantially reduced. Why that is important is obviously regulations are put in place to try to protect the public. Governments have a vested interest in a healthier population, and they should have that vested interest. But as we've seen in the past, as I mentioned, even historically monarchs not being able to stop smokers at the threat of death, you have to accept that there's going to be some

level of usage regardless. And if you use too heavy-handed of regulation or you raise taxes too fast there's clear risks that you push some of the market into the black market that you don't have eyes on you don't have control of and that becomes much more problematic and so governments around the world are starting to embrace tobacco harm reduction frameworks in their policies. Now, a large part of that is recognizing that while these next-gen products aren't inherently safe, they're substantially safer than cigarettes. And so doesn't it make sense to try to shift consumers that either are using or would use cigarettes to these new products If your ultimate goal is to have a healthier population, I generally take the view that that does make a whole lot of sense.

And at the same time, we should use regulation to do things like restrict underage access and usage of these products. Again, adults, I generally hold the view, should be able to make their own decisions and do what they want. So you give them a wide variety of products and let them make their own choices. Now, what really stands out about these next-gen products, these reduced-risk products, is that to incentivize consumers switching to them, there are governments that are taxing them at lower rates compared to cigarettes, and that's absolutely critical. Like I mentioned before, around the world, average pack of cigarettes, 50% of the retail price is taxes. Let's say you cut that tax burden in half, even with RRPs being not as cheap to make as a cigarette. If you reduce that tax burden, you can make it so that the retail price for the consumer

is less than cigarettes and therefore more appealing, while at the same time actually being higher margin and more profitable for the manufacturer. It seems to be a situation where I think all these key stakeholders have a vested interest in having this just naturally unfold and more and more regulatory bodies around the world really pushing this framework of tobacco harm reduction and promoting these types of products. Do you have any numbers on British American tobacco specifically with their vaping and in nicotine pouches? I mean, how, as a percentage wise, how big of the business is it? If you don't have it in front of you, that's okay. I got it up here. All right, good, good.

So it's important to realize that these, the major manufacturers, they've been researching and developing these products for a very long time, but really in terms of commercial availability and growth. We didn't really see much until 2016. And it was only in the last couple of years that things kind of really took off. Because you think about it, you have to engage in substantial R&D because with regulators, you need to be able to scientifically substantiate your health claims, showing that these products are at least no worse than cigarettes. But realistically, again science suggests much much safer along with that you have to scale production you have to focus on distribution you have to raise consumer awareness while at the same time you're greatly

restricted in how you can market and advertise so that's a very difficult hurdle but in the past few years for for british american tobacco specifically we we've seen tremendous growth I think in 2021, for their three new categories, their next gen products, they saw 51% top line growth. In the first half of 2022, that was 45% revenue growth. But what's very interesting about that is that that revenue growth is in the first half of 2022 was quite a bit higher than the volume growth that they saw, meaning that they're starting to scale back the steep discounting that they've been doing and are starting to exercise pricing power for these new products. And so as growth continues and they can exercise pricing power, there's got enormous opportunity for them to turn these into two very lucrative segments. For BAT as a whole, non-combustible sales made up 14.6% of revenue in the first half of 2022. And I believe if you take out traditional oil, the three new categories made up around 10%. And again, when you look at year-over-year growth rates, it's very likely it's going to decelerate.

You can't have too many things in the world growing at 40%, 50% each year, year-over-year, and have it maintain that. But even with decelerating growth on top of exercising pricing power, I think we're going to witness something pretty impressive for the company. It's important to note that when you look at the total investment and all the costs associated with getting to this point, that these new categories in aggregate aren't profitable for British American tobacco. Certain products in certain markets are currently profitable, but in aggregate, they're still losing money. However, those losses have fallen dramatically. And again, all it takes is continued scaling, exercising pricing power. We see that these, which are a non-trivial part of revenue and fast-growing, that are still loss-creating, if and when that flips to profit generating and again if those taxation dynamics for rrps persist can be margin

accretive to the business as a whole then i i think we might be witnessing a you know a very different story in terms of the potential terminal value of british american tobacco compared to the the traditional narrative which is smoking down volumes down terminal value gone dinosaur all All right, that leads to my next question. What do you think is more promising? And I guess the answer could be both vaping, the vaping category or nicotine pouches. That's a tough question.

I think that overall that this industry and how it unfolds, it's not going to be a winner takes all situation. And I think that's going to be true for both categories as well as really companies. I think that there's multiple players that can do exceedingly well. And I think that when you look at how diverse the world is, you factor in consumer preference, affordability, societal norms, and different regulatory frameworks around the world. There's going to be certain products that just do exceedingly well in some areas while falling flat in others. And I think that all three are likely going to do well. With that said, I'm a big proponent of the modern oral segment.

I think the tobacco-free nicotine pouches represent something very, very interesting. One, from the studies I've looked at, they seem to have the lowest risk profile, being somewhere very close to nicotine gum, and just substantially lower. 99.8% less risk than cigarettes or something like that. But what's great about this product is that they're exceedingly simple. They're fairly cheap to make. Again, they're much lower risk, but they're also extremely discreet to use. You know, smoking is not a discrete action, and vaping, while a little bit more discrete, is still rather obvious. With these tobacco-free nicotine pouches, you pop one in, they don't stain your teeth, they don't give bad breath.

You don't have to spit like you do a traditional chew or anything. um and for these reasons you know you you see a growing acceptance rate and a usage rate across a number of different legal age ranges as well as a growing acceptance amongst female users which is really interesting because for traditional oral tobacco that's a segment that historically has been something like 95% male users. And I think, going back for a second, thinking about the cheapness of the product, you can have very, very wide margins on a product,

but have it still be very, very affordable for the user. And that's going to be something exceedingly important in emerging markets where you can't charge a ton for your product just because there's not that same level of buying power. And when you look at a segment like heated tobacco, where the heated tobacco units that that device uses might be cheaper than cigarettes, the device itself might be prohibitively expensive, right? In an emerging market that will really curb adoption. So yeah, if I have to go with one, I'll say Modern Oral. But again, I don't think it's winner takes all. I think they're all going to look pretty good. Sounds like our old Swedish match pitch. I want

one quick follow up on that. Swedish match is the number one player in nicotine pouches, at least in the United States. And I think maybe if you add it up globally, probably globally at this point but british american tobacco i believe is second i mean what kind of progress have they had there it seems like they've really done well the last few years in the nordics and kind of expanding throughout europe yeah uh you're exactly right about that swedish match is is still the the dominant player and critically they they still have the lion's share of the u.s market which which is just wildly profitable um british american tobacco they have their own modern oil product under the brand of velo and if you if you look in these scandinavian countries

it's done exceedingly well and has continued to incrementally take share from swedish match in multiple countries they're just completely dominating you know 60 70 80 plus of the market And seemingly growing very well throughout other parts of Europe. Now, British American tobacco, as I mentioned before, they also operate in the U.S., but the Velo in the U.S. is actually a different product than the one we've seen succeeding in the Scandinavian countries. And from what I've seen by all accounts is that the U.S. version is not just inferior to their European version. It's inferior to almost all other modern oral products where consumer accounts state it comes in cheap, flimsy plastic cans, poor packaging, poor labeling. The pouches just don't feel as good. there's excess powder in the cans that the flavors are a little off there's um there's you know weird

aftertaste and just overall that is good as an experience in any measurable way and so that definitely shows up in the us numbers uh in the past few years uh velo has shrunk in market share shrunk in volumes while at the same time uh zin is is shrinking the market share but growing volumes at a healthy clip and ultras on oral nicotine pouch is both taking market share and growing volumes um so so british american tobacco has stated they have a pmta pending for for the other version but there's no guarantee it gets into the united states um i'm not assuming it does anytime soon i do think if the other version gets into the united states i think that could be a game changer again from all the accounts of what i've heard from user experiences as well as the

the numbers in terms of bats reporting and independent reporting uh you the european version if it gets in the us shouldn't do exceedingly well okay let's talk a little bit about uh bti's valuation specifically um how are you valuing the stock today um can you give maybe just some numbers uh so listeners maybe have some context around what the valuation looks like sure so i think it's important to start off by by remembering that the the tobacco industry as a whole operates on pretty compressed multiples just if you look at bat right now it's about nine and a half times times evita evita uh which is you know considerably lower than quite a few companies out there and it's important to note that like while you can compare that to other

companies. This is also an industry that has very minimal reinvestment needs. So when you factor in things like CapEx and DNA, and even even R&D for for the new new products, it's incredibly capital light. And so you have incredibly high margins, you're trading in a compressed multiple, it's technically at a double-digit free cash flow yield right now. If you just look at the simple numbers, you can also look at, they have a 65% target payout ratio of adjusted EPS denoted in pound sterling. They have a yield right now that's sitting at about 7%. This year, they started a buyback program to run through the whole year, that would be about £2 billion. And they've signaled that they intend to continue to do buybacks in the future. So you have a 7%-ish

yield, greater than 2% buyback yield, along with this, since 2017, and as they've been growing all these new products that are fast growing, and are potentially going to flip to profitability. they've been meaningfully deleveraging right since that that 2017 acquisition of rentals and so all it really takes is tepid growth and really for the core business not to degrade and see volumes declines faster than the rest of the business you know continues to to do well and i i think if you look at the numbers it has a real good shot of achieving that and so you know that easily puts you into double digit territory and if things start to look any better if cigarette volumes you know uh hold up a little bit better or they can exercise better price and power

or maybe cigarette volumes decline faster but that's because they're being cannibalized by these new categories that they can scale raise pricing on um there's all kinds of scenarios where maybe you know a low double digit uh irr gets pushed into the teens mid-teens maybe even high teens all right one one quick follow-up there and this might just be wishful thinking because we know they're going to have the payout ratio but would you rather have them allocate to buybacks given that they have these growth categories that maybe other investors can take advantage of if they have a lower share count you know going forward it's a good question um you know both dividends and buybacks are

are capital allocation decisions that are similar to each other they're they're they're a form of returning capital to shareholders right excess capital and so I would say I'm most concerned or most interested in making sure that management is focusing on deploying capital where it needs to go. And so at the end of the day, if they look at their new categories, they look at other investment opportunities to reinvest into the business. if they think that they're meeting all of their targets and they're taking advantage of the best opportunities

and there's still cash left over, I think buybacks are probably the route to go. Again, I think they'll continue to be leveraged. They aim to keep their adjusted EBITDA to EB, adjusted debt to EBITDA, sorry, between the two to three range. And I think I'm getting it down to like two and a half is probably a reasonable level on the signal signal as much. So they accomplished that.

And if things continue to do even just a little bit better, just incremental, just minimal growth. Yeah. I think, I think they'll have extra, extra cash and yeah, I'd love to see it go to buybacks. I mean, it has to go somewhere, right? Because they can certainly keep it on the balance sheet. Rainy day fund never hurt anybody. And again, that might allow them to take advantage

of other opportunities in the future. But when it's trading that, what I view as such a depressed multiple, I think buybacks are incredibly advantageous right here. All right. Well, we have one more question. Unless Ryan, you have any follow-up? No more follow-ups?

All right. this has been a great overview of BTI, but we got to finish it up with the risks here. Pre-mortem, what do you think, I mean, what have you been looking at as maybe any sort of risk? Has it been competition? I guess, you know, maybe we already discussed how there's really no competition, but what could go wrong here with an investment in BTI at these levels? Yeah. I mean, that's obviously a question you always have to ask yourself when you're selecting individual assets or equities or whatever it might be and i think for british american tobacco there's a long list of things that could make this go not well for the company

and so you know in my own research and writing i've said as much i think at least for the industry british american tobacco might have the widest range in potential outcomes some of the risks that i spent quite a bit of time thinking about are one obviously future regulation in that historically you know my core thesis and i think it shows up in the numbers is that regulation has actually been a net positive for the major manufacturers really blocking out competition insulating them allowing them you know to exercise that immense price and power Um, and, and my, my concern is, you know, just cause it's done that in the past doesn't mean it will continue to do that in the future.

If, if governments begin to stray away from, or, uh, governments don't accept tobacco harm reduction frameworks and they're in the regulation, uh, policy decisions, or if they decide they're going to, for some reason, start taxing these products substantially higher, or maybe they decide that, hey, we're going to target these specific types of products, and we're going to just ban them entirely, and we're just going to let cigarettes continue to dominate our market, you know, those types of things could happen, and they probably will happen in certain markets um and and so i think that's something to be cognizant of i think as again as i've laid out i think that all the major stakeholders kind of seem to benefit from

having things shift towards tobacco harm reduction policies but um yeah we'll see how things unfold in that regard similarly i think it's important to remember that these new categories are are aiming to kind of bolster the terminal value of of these companies british american tobacco especially like we know that eventually cigarettes will be a thing of the past i think it's going to take much longer than many people say but eventually they will be gone so what's left over it's like well you'll have these new categories but perhaps one of the greatest risks is that But while with cigarettes, you have this tremendous brand loyalty where, you know, if somebody goes to buy their pack of cigarettes and the convenience store doesn't have their brand, they will leave and they'll go somewhere else. They'll find their brand, right?

They're not going to sell for something else. With these new products that have only been around for a little over half a decade, if brands aren't able to establish themselves and build that consumer affinity, And if regulation no longer kind of boxes out small competitors, there could be a flood of competing products. And without that brand affinity, then it becomes a pricing game. And if you have a pricing game and it's a race to the bottom, and that's exactly the opposite of what has happened for the legacy product. So I think that's a tremendous risk that shouldn't go unnoticed. Okay, do you have any other thoughts? Yeah, I mean, there's so many risks.

I mean, I'll touch on two more of the most obvious. is one like you know that operates globally they are at risk in terms of things like deglobalization or all kinds of wrenches thrown into the gears that is the global supply chain and also uh forex dynamics you know they operate in a lot of different currencies And, you know, transactionally and translational, those have different, you know, headwinds and tailwinds for the company. But ultimately, you know, it is a threat to the company, I think, long term. And while they derive about 55% of their operating profits in the U.S. dollar, and the U.S. dollar has been strengthening, that whole U.S. dollar wrecking ball for the rest of the world, there's ramifications just to the health of the global economy. Again, this industry is rather resilient throughout economic cycles, but it's definitely something to be mindful of.

And then, you know, the last thing I'll definitely have to touch on, just maybe not in terms of operations, but in terms of shareholder returns, is, you know, the ESG movement. You know, this company is in an industry that is largely vilified. And there have been a lot of proponents in the ESG space that have been pushing for institutional investors to sell their positions, not touch the space, been pushing for banks to not do business with the industry. And there have been a lot of questions around the terminal value of these businesses. And so because of that, their multiples have contracted. And it wouldn't surprise me in the least to see that continue. Even though I think, you know, British American tobacco is attractively priced at this multiple, it can continue to re-rate and go even lower. There's no law saying it can't, right?

And so I think at least in the short and medium term, that seems like an obvious risk. Again, as somebody who's looking at this business from a fundamental perspective, that really doesn't concern me. I think if their multiple gets pushed down even more, again, as they're growing their buybacks, I think on a longer-term outlook, that's a net benefit. You can't say that for all companies, especially recently high-flying tech companies where they sell off. And some people cope by saying, oh, great, now it's on sale and I can buy more. Great. And it doesn't matter. But those companies that they're not profitable and they rely on heavy stock-based compensation like share price definitely matters um for for british american tobacco and the tobacco industry broadly

like stock-based compensation is is negligible it's practically zero and so you see the stock price going down and they're starting to engage in substantial buybacks then you know a cheaper share price is just going to to have a multi-plicative effect as the multiple continues to to compress balance okay perfect well i think that's going to do it it's all the questions we have for any listeners that want to keep up with you what is the best place to do that yeah so uh currently writing on sub stack so if you want to check out my writing i cover have been covering the tobacco industry pretty in depth but cover you know other companies and we'll be probably branching out in the future you can check out the writing um it's invariant

dot substat dot com or you can reach out on twitter devin lasar which is d-e-b-i-n l-a-s-a-r-r-e and uh yeah dms are open so happy to chat with whoever awesome well that is going to do it we want to remind our listeners that Brett and I are not financial advisors. Anything we say or discuss is not formal advice or recommendation. We are, however, general partners at Arch Capital, so clients may have positions in the securities discussed in this podcast. Thank you all for listening. Thanks again to Devin for coming on the show. We'll see you guys next time.