Yet Another Value Podcast - Bireme Capital's Evan Tindell on British American Tobacco $BTI and tobacco's inflection point

Episode Date: February 19, 2024

Evan Tindell, CIO of Bireme Capital, joins the podcast for his fourth time to discuss his thesis on British American Tobacco p.l.c. (NYSE: BTI), the company engages in the provision of tobacco and nicotine products to consumers worldwide. For more information about Bireme Capital, please visit: https://www.biremecapital.com/ Evan's $BTI write-up in Bireme Capital's investor letter: https://www.biremecapital.com/blog/december-2023-investor-letter Chapters: [0:00] Introduction + Episode sponsor: Fundamental Edge [2:04] Overview of British American Tobacco Company and why they are interesting to Evan [6:42] What Evan thinks his edge is with $BTI / comments on stock performance over the last few months [11:58] Vaping, regulations and how this affects $BTI [18:38] $BTI annual report [25:24] Competition from non-regulated folks / legal liabilities for new $BTI products / menthol cigarette ban [34:00] Doom-looping on cigarette industry [38:00] $BTI's ownership stake in ITC (formerly known as India Tobacco Company) [43:43] "Sum of the Parts" stocks[51:07] $BTI capital allocation strategy Today's episode is sponsored by: Fundamental Edge You’ve probably heard it’s an “apprenticeship” system, or that you’ll “learn by osmosis”? But what if there was a better way to learn the equity analyst job? Fundamental Edge is re-defining training on the buy-side. Use the code "10YAVP" for a 10% discount. Website: https://www.fundamentedge.com/ Whether you’re already in the seat or looking to break in, the Analyst Academy from Fundamental Edge offers a thorough and flexible path to developing the tools and frameworks employed by leading hedge funds. Breaking in: https://www.fundamentedge.com/breaking-in Check out the Academy syllabus and sign up for future free content: https://fundamental-edge.ck.page/academyinfo

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Fundamental Edge alumni get access to exclusive webinars, case studies, and an invite to their first annual analyst spring training conference in Arizona. If you want to fast track your byside career, go to Fundamentedge.com for more info. That's Fundamentedge.com. All right, hello, and welcome to yet another value podcast. I'm your host, Andrew Walker, also the author of Yet Another Value Blog. If you like this podcast, it would mean a lot if you could rate, subscribe, review, wherever you're watching or listening to it.

With me today, I'm happy to have one. I believe for the third time, though, you know, second time people get the hat. I know Evan's got the hat. Oh, I do have the hat. I'm not wearing it, unfortunately. Yeah, sorry. You know, I actually have the, I have your hat. I told myself a couple weeks ago I'd wear it on the podcast and I just got into my traditional thing. I'm looking around. Evan, how's it going? Evan, how's it going? I'm doing well. How about yourself? I'm doing great. Look, super excited to have you today. I knew there was passion behind this company. I didn't know quite how much passion there was. So I've posted on Twitter. But let me do the disclaimer and then we'll get there. Everyone should remember, nothing on this podcast. podcast is investing in investing advice, please consult a financial advisor, do your own work, all that type of jazz. So Evan, the company we want to talk about today, and I'll include you wrote it up, you did a great write up in your Q4 letter, I believe. It wasn't Q3, it was Q4, right?

Yeah, Q4, yeah. It did a great write up in your Q4 letter. So I'll include a link to that in the show notes. People can check that out if they want the written word. But the company you want to talk about today is British American Tobacco. They trade in London under Bats. I believe it's BTI in the U.S. So I'll just toss it over to you. You know, who is bats? Why are they so interesting? Why are people so passionate about them?

Sure, yeah. So they are a tobacco company, one of the largest tobacco companies in the world. I think they might be the largest or second largest in terms of, in terms of revenue. And they have a large U.S. business. They have a number of like well, well-known brands, Kent, Dunhill, Camel. Newport. Lucky strike. You got to include the lucky strike.

Yeah, there's just so many brands. And I think they're in a really interesting situation because the, you know, the tobacco business historically, these stocks have done really well because, you know, they trade it. They tend to trade at cheap valuations. And while volume declines, they're able to typically grow, still grow revenue like a low single digit amount by raising prices over time. and then it's all basically everything drops to free cash flow. So, you know, you have a situation where stock trades at, you know,

eight, nine, ten times earnings for a long period of time. And if they can buy back stock and pay a big dividend, you know, you can see really good results, especially if the stock re-rates. Now, I think there's sort of an inflection point here for tobacco companies because of the growth in what they call reduced risk products or, you know, some of the companies call them next generation products. And these are nicotine products that aren't tobacco, typically. So, you know, you're basically, instead of burning a bunch of leaves in your mouth,

you're either you're chewing on a pouch or you're breathing in vapor or you're breathing in, you know, heated but not burnt tobacco. I guess that's also a vapor technically. I don't know what that is. I don't know what that thing is smoke. And so today, the stock is. has gone from, you know, traded at 15 or 20 times earnings a few years ago. And today, for various reasons that we can get into, the valuation has come down a ton. It trades at, you know,

seven times earnings, roughly six times, depending on, you know, whether you're looking out a few years or what have you. And while the U.S. business, the U.S. combustibles business, like the U.S. traditional cigarettes business is pretty challenged. And one of those major challenges is the fact that a huge percentage of the revenue comes from menthol cigarettes, which the government has talked about banning a few times. But while the U.S. business is challenged, the rest of the world has been performing pretty solidly. And they have, you know, besides Philip Morris, they have by far the largest next generation products business, which has grown.

grown to be, you know, around a little more than 10% of their revenue. And it's on the way to, I think, 30 to, you know, they've given guidance that it's going to be 50% by 2030, which obviously is a, you know, very far out guidance. So you maybe take it with a grain of salt. And so I think they're in a situation where, you know, if you can buy this thing for seven times earnings and they can grow the sort of reduced risk products revenue to become a material fraction of the overall business. I personally think that, you know, tobacco companies could re-rate to 15 to 20 times earnings over the long term as people realize that these businesses should be stable over the long term because it's actually not the nicotine that kills you. I don't know. Most people

don't even don't realize that. I think they've done surveys where most, the minority of people think that it's actually the nicotine that kills you, but really, but it's actually the everything else that goes into a cigarette as well as like the burning of it in your mouth and the ash and the tar and all that stuff. So I think you have an opportunity to buy these companies as they transform from, you know, traditional tobacco companies to, you know, more normal consumer products businesses that should have consumer products business multiple. And on at least on an earnings multiple basis, BAT is, you know, one of the, definitely one of the the cheaper ones. So it's a fascinating idea. I mean, I loved your write-up. And I'll lead the

witness. My favorite part of your write-up and where I really want to dive in in a second is I love the work you did on the next-gen products and the margins that are they're capable of because that was when I was researching, that was the first question. But let me just, we've got that to talk about. We've got ITC to talk about. We've got all sorts of stuff to talk about. And I promise listeners, we're going to try and get there. But let me just start with one quick question, right? Like, this is a 9 to 10% dividend yield, 6 to 7 times P company, $50 billion market cap. They put out a lot of projections. They tell you what they're going to do.

You know, maybe they're not. They basically return all the cash to shareholders, right? It's a decently followed company. So I just want to ask, you know, you're a former poker player. I'm always thinking about where my edge is. You're always thinking about where your edge is. I just want to ask, what do you think your edge is here, right? Like whenever I wait into a 20 billion plus company, I'm always kind of thinking.

thinking like, hey, you know, I'm playing with the real big boys now. We're not at the poker player drunk 3 a.m. We're playing with the, I'm playing with Evan Dendells. You know, I'm playing with people who know what they're doing. So what do you think your edge is when it just comes to this? Yeah. I mean, I think, I think historically the, um, the edge, uh, or the, you know, the reason why people kind of ignore these stocks, uh, has to do with, has to do with just kind of the eckiness factor or the ESG factor with respect to tobacco stocks. Like, you know, there's just probably 30 to 50% of people out there don't want to own, I think, tobacco stocks for any reason. And that includes portfolio managers. I mean, and also this thing primarily trades in

Europe where, you know, the ESG mandates are, I think, more stringent usually than they are in the U.S., which I think tends to lead to, you know, even more dramatic gaps in valuation. and if you if you are interested in um to like kind of like the tobacco esg story there's just a much better stock in fact that's your primary concern you buy philip morris right um like that like if that's like your main concern just because they're further ahead on next gen stuff or is yeah exactly they're just you know they're like 40% of the business is um it is is next gen so if that's like your main thing you you you um you buy philip morris but you know they trade it at 14 times earning things. So, you know, I think it seems pretty clear that that's where the, that's where the

kind of people are investing if they have any concern about ESG. And it's, and Phil Morris is still cheap. And it may be, it may be undervalued as well. But I, I, it's just in my, my blood to kind of gravitate towards whatever is a little bit cheaper. Like I, you know, I'm the same way. Let me ask one more stupid question. Then we can dive into the real meat and potato's a thesis. Like, I just, you know, Bloomberg GP or whatever. And the stock has come down from, the high 30s last year to the low 30s, I mean, basically 30, as you and I are talking. You know, it's been a pretty bullish time for markets over the past year. It was volatile. I think people forget in October, people were desponded. But when I look at something with this steady

of cash flow growth, like yields kind of having leveled off, it just, it seems like we'll talk positive news on the ITZ front. What's kind of changed over the past few months that's kind of sent to the levels where I think you think it's a value? Yeah, I mean, there's been, they've had a number of of kind of short-term problems. I mean, one, one major one was the ban on menthol cigarettes in California that went into effect at the end of 2022. You know, obviously, it never, it never helps to have the regulators, like, just come out and ban, you know, a major product for, for you. And then the other thing that's happened is there's been, I know this is like the number one concern for everyone, there's been this giant rise in disposable vapes in the U.S.

So the U.S. is the largest market for vaping, and their product, which is called Vuees, has done a really good job at taking market share from a battered and barely existing jewel. And so as far as like the legal, like FDA approved segment of the market, they have almost 40% market share. but the thing is for the approved markets, you know, for people that actually care about following the law and FTA regulations, you're not allowed to sell flavor. Yeah, you're not allowed to sell cotton candy. You're not allowed to sell like breakfast cereal or, you know, whatever other, you know, flavors that companies are trying to sell. And the disposable brands, which are mostly from China, have basically said, we don't

give a fuck. They're saying, we're going to keep putting out all the, all the flavors. And that's caused them to basically take, I mean, BAT says 60% of the market. I've seen other estimates at 50%. And so what actually happened in the past year was they actually lost volume in their vape product in the U.S. I mean, they wrote, they increased prices. So they did see a growth in revenue. But I think that, you know, kind of the rise of the disposables has also, spooks the market somewhat in terms of, you know, the implications for the long-term value of the vaping business. If I can just clarify for listeners to make sure I understand that they understand and everything, what this is, and I've seen so much good reporting on this. What this is is,

look, cigarettes are highly regulated, right? And vafs all this sort of stuff, technically they should be highly regulated. And please at the end, just tell me if I could even. I would even say technically they are highly regulated. Yeah, they can't sell them. Yeah. But what's happening is from, mainly from China. There are very cheap imports that, you know, again, cotton candy, jewel seven years ago, every kid was doing cotton candy babes and you generally don't want 14 year olds getting hooked on nicotine, right? So jewel dropped it, FDA banned cotton candy.

But all these Chinese imports have come in with very cheap imports, skirting all the laws. And you know, when you skirt the laws, it's great because you can sell people highly addicted products and you also don't have any of the regulatory burden of following through. Like, that's just a huge cost, like not having to get his regulated spec. So they're coming in. I think they're selling mainly through like bodegas and stuff, right? So they're selling all these illegal cotton candy products and it's just huge. And it's taking a huge share from the people who are saying, hey, we're following the regulations.

It's controlled substance following that. We're not selling the cotton candy. Am I kind of thinking about that correctly? Yeah. They also sell through, through vape shops, which have some amount of legal products, but also just tons of illegal products. So, yeah, it's a few different. Yeah, but it's just for sure hundreds of thousands of locations in the U.S. So would this be something where if I woke up, I mean, if I was dead by an administration,

I feel like this is an area of bipartisan crackdown potential, right? Like what parent is going to hear, hey, we're cracking down on cereal flavored nicotine products and selling them to underage kids or 18 year olds and be like, oh, regulatory overreach. I don't think there's any. But if I'm into BTI, I mean, is this one of those things where I hope I pray a year from now, six months from now, whenever it is, there's a, you know, FTC, hey, we are cracking down, we're grabbing these at ports, we're putting huge fines on retailer's

some, and the stock's up 30% because people say, oh, our regulatory nightmare is over? Is like that kind of the hope? Or is there something else there? I mean, it's, it's, I don't know that I have a ton of confidence that there could be one single thing that would send it, that would do it. Why not? Because, you know, I, I actually, I don't know, because it seems like they're not able to, because it seems like they're not able to really figure it out at customs. Like, it's like it's like we can stop i mean cocaine is yeah i mean so i'll say this yeah so long term it's it feels to me unlikely that this would be the one product that you're just able to like buy an illegal product like no questions asked in the store like there's no way that they're

going to i don't think that that long term that you can just buy illegal products in like normal retail stores but i mean like so the fda has been has been putting out warning letters and they've been putting out, they've been issuing like civil monetary complaints. So the way the FDA is doing it so far is they're basically, it seems like they're taking individual products like the elf, elf bar, or the next one was like escobar or something. And they're like following those products to retail locations or wholesalers. And they're putting lawsuits against those, retailers or those wholesalers,

but there's just so many of them that they're not able to make a dent in the local supply is what it seems. But I frankly don't understand why they're not able to seize it at the border in a more

in a more systematic way. I both believe it and I have trouble understanding it because like, so in NYC, right? before marijuana really got legalized, apparently, like, once it was decriminalized, but kind of in 2020, 2022, decriminalized, but not legalized, apparently all the bodegas, and I never do anything illegal, so I had no clue, but I heard this, all the bodegas, if you went up to them and like, hey, I want some weed, all of them would sell it to you.

And what would happen is once a week, a cop would come in and say, hey, I want some weed, and they'd sell it to them, and then the cop would hit him with a $300 fine, or $500, whatever it was. And all the bodegas did the math, and they're like, oh, we'll just, pay the spine once a week, and it's completely worth it for us to keep selling this product. And so, like, I do hear you like they, but when you say they're following them to the retailers and going and hitting them with lawsuits, like, I am surprised if I'm a bodega in New York or whatever, like, the retail is that wide open when they're hitting them with lawsuits. And like, that's a bigger crackdown than weed, which was decriminalized and everybody knew

where the puck was going versus, you know, selling a 15 year old, selling a 15 year old, a cotton candy flavor jewel. Yeah. And so if you look at like BAT's presentations, they talk about like five different like methods that they're trying to attack this, like the International Trade Commission, FDA warning letters and import alerts and wholesaler raids. They're talking about like trying to seize them at the border. They're talking about going through Congress, talking about seizures from the local police level. But it doesn't, I'm not sure exactly. I mean, I think unless I don't know. I don't know. It seems like, I feel like it's, my guess is it's going to be like kind of like a building momentum thing where like more, they're just, they breaky broadening and broadening like the ways that they try to crack down on it. And then eventually these shops kind of realize that it's just not in their best interest to continue. And they, but I mean, I went, I bought a elf bar like a month ago in here in Maryland just to see. And I was like, do you know? I was like, are these like legal? Like I had no idea what I was talking about. I was thinking the guy would have sound like, okay, Narc, we're not selling you this. Yeah, yeah, yeah, yeah, yeah, like, exactly. I was like, are you a lot of time?

He's like, I, he's like, I, what? Brett Coffron, founder and lead trainer of Fundamental Edge, barely remembers his first year as a hedge fund analyst. Most of the year was spending a blind panic. Was his research any good? Was he learning fast enough? What did his PM really want from him? Training on the by side was non-existent 15 years ago

when Brett was a new analyst at Maverick Capital. And he actually got demoted. Then he worked harder, found mentors, and asked for uncomfortable feedback. Eventually, he turned it around, learning by osmosis from the talent of people around him, and rose to managing director. But is this the best way to develop talent?

Brett doesn't think so, and that's why he founded Fundamental Edge. The Fundamental Edge Analyst Academy provides students with the tools, frameworks, and confidence to excel in any fundamental equity analyst seat in the industry. Lose the panic and fast track your career on the by side. Find out more about their next cohort at Fundamentedge.com. Let me... So just sticking with the new march, you know, one of the things, ignoring that, which is a really interesting angle to this, right?

But ignoring that. So BTI comes out and if you read their annual report, and I read there in your report and prep for this, you know, the first thing they lead off with, they're talking about smoke lists, they're talking about new categories, they're talking about the future, all that sort of stuff, right? And then the first thing that jumps out to me is, okay, cool, you're telling me you've got this great growth angle, all this stories. But the two things that jumps out to me was, one, 81% of your revenue is still from combustibles, which is legacy cigarettes, right? So all of your revenues from legacy cigarettes. And as far as I can tell, they do not split out the margins for all of the new stuff that they do. Right. Now, they did say on

the 2020 earnings call, they said, hey, our new age stuff is a category profitable. We hit that two years before, two years ahead of target. They've said that their operating margins on the new stuff is similar to cigarettes, but they haven't disclosed it. So I wanted to ask you two things. I guess three things. Number one, it's a little crazy. You know, I'm sure you're the same way when you see someone leading sexy gross or it's like, hey, 85% of our revenues from declining stuff. I'm like, oh, that's, but the two, second thing is, what do you think the margins of, what do you think of the margins of the new stuff is? And I'm giving you a softball because, again, you did such great work. People can see it in your letter. You did such great work on busting out some other comp margins. But, you know, do you believe they can get to operating margins? Do you think there's a pot of gold at the end of this rainbow? Yeah. I mean, I guess the the first thing that I tried to think about when, thinking about, because this is a big topic of debate between me and my, my business partner, Ryan. And the first thing is, like, if you just think about the unit economics, I mean, like, cigarettes are some of the most profitable products in history, obviously. And it doesn't cost much more on like a per unit basis to manufacture these things, especially at scale.

and they have a benefit versus cigarettes, which is that they're much more lightly taxed generally. So they're typically able to retain a larger share of kind of like the retail price that you're seeing. And so that combined with the fact that the selling price is sort of similar to cigarettes was the first thing that I thought about when I was like, okay, well, if they can sell it for $6 and it's cost $1 to make and the tax burden is pretty low, then, okay, that seems like something that at least,

you know, from a unit economics basis, you know, it should be profitable. But then, of course, you know, you could spend, I think I said in the letter, like, you can have a gross profit positive business that is like a dog fight in terms of everything else, like marketing and you lose all the profits on the rest of it, right? So that, obviously, that part, the second part is a little bit tougher to kind of handicap, but what I look at is the profitability of sort of the scaled businesses that we already have. And those are primarily inside of Philomorris. And so, you know, you could potentially, you could potentially criticize this analysis by saying that maybe Philip Morris's brands are

better or, you know, there's just something different about Philip Morris. But what we see with Philip Morris is basically they've scaled their Icos business in in Europe and a few other places, but primarily Europe, to, you know, basically 40% of their revenues. I mean, part of it is the Swedish match pouch business. They could keep a pouch business, but their ICO's business is, you know, maybe 30% of their revenue. And it's their profitability has not gotten hurt at all. In fact, they claim that it's going to continue. to grow over time their margins. And that's just for the reason I just said, you know, they basically, they sell at a similar retail price. There's a lower tax burden. The manufacturing

costs at scale is lower. And while you would think that, you know, because the markets are theoretically, like more open than, you know, cigarette markets, because like, you know, for example, people talk about why cigarettes are such a good, it's such a good business because people haven't been allowed to market to like advertise for so long. So you have this kind of stagnant industry, industry structure. And you have an oligopoly there where it's almost impossible to break in. But I think the data so far kind of shows next generation products to be similar. I mean, like, you know, in the five markets where BAT has pushed, strongly pushed their nicotine pouch,

which is most of like the Nordic markets, markets, they have really, they have like giant market share. It's already profitable. And it's been tough for competitors to break in. You look at Zin in the U.S., the Zin pouches are like 80% of the market and other competitors are struggling to break in.

Like, what I see in the next generation products is except where the competitors are these like unregulated brands that have an advantage in terms of flavors. I find a very, A, a pretty tightly regulated market in most places, and B, just not a lot of new entrants that are really gaining share. I mean, you pretty much see Phil Morris, Altria, and BAT, and that's it, except for the unregulated products. So I think that, you know, the company has guided, as basically said, you know, they, they said categories.

contribution market margin of 20% last year in their top 10 markets. Now, obviously, there's a number of caveats there, right? There's like contribution margin. There's top 10 markets and all these things. But, you know, they're claiming that gross margin has gone from 35 to 56%. And that they're going to continue to kind of scale up in terms of, in terms of contribution margin. But so I think my guess is that long term, you know, if operating margin in cigarette business

is 50%. I'm modeling like, just to be conservative, I'm modeling like 30%, which I think is more of like a, you know, it's closer to like a beer margin maybe or like a just like a solid branded consumer products margin rather than like a cigarette margin because it probably is going to be more open than cigarettes long term, I would guess. But I think they're, I think they're going to have already, you know, they're going to have a pretty big advantage in terms of how, how, long they're going to the runway that they're that they're developing right now well you did a great job of front running all the questions i was going to ask you right because my initial worry when i look at this as a okay cool cigarettes have been great but as you said no marketing like huge

farming operations all this sort of stuff nobody in the right mind's going to come in with the legal liabilities and stuff uh versus the the new stuff i i just wanted to pull on one thread since you you hit on everything i did when asked you know we just talked about how much share the non-regulated guys are taking, right? And just to explicitly say, in your mind, they're not taking share because they're, like, way undercutting on price or anything. They're really taking share because they are hitting the most addictive, most tasty flavors that people, you know, kind of crave and people want, but they're the stuff that has been regulated away, in my opinion, for good reasons. But they're really winning on illegal flavors, not because

they're undercutting on price or any other advantage. Yeah, I mean, that's, that's what I see. Um, you know, I, I think there's a, there's a, there's, um, yeah, I mean, it's, it's like, even within, even within, like, if you go to the, the, the store, um, even within like the elf bars, there's like a huge difference in like how the different flavors sell because people just love certain flavors. Like, apparently Miami Mint is like the number one flavor and like everyone gets that one. But, um, yeah, I think it's just, I think it's just a huge advantage to be able to have flavors. So, yeah. I'm obviously Googling Miami Mint. I've, I've never smoked a cigarette or, um, e-sig or vapor in my life Miami meant it's I will say man it looks like this it's a it's a quite a it's quite a oh yeah that's the thing that popped up in my Google dude are you using the illegal flavors this is going to I would never no I just I had to I had to I had to confirm the the status of its sales in Maryland so I I I know this is the one I bought this is the one I bought in the store I bought it like a couple weeks ago just to see and the guy had no idea going to get it does look really cool though like something about that green looks

cool. It's a nice packaging for sure. One other question, just on the new categories, right? Like one of the things that both made the tobacco company such great businesses and was a disaster for them for a while and created barriers and injuries was the huge legal liabilities, right? So they had these huge legal liabilities effectively. They make the government into their partners.

Obviously, the health risks are a lot lower with they being in non-burn and everything. But they're not zero. And I don't think anybody started to accrue. liabilities for state governments and stuff, is there anything on the horizon with legal liabilities for these new products? Have they started even accruing anything along the lines of these? Or is that just unknowable too far out of the future?

Yeah, I think it's unknowable. I mean, yeah, if you look at like biomarkers for like various cancers or other types of health risks, it looks like the risk of all of the next gen products are way, way, way lower. like the UK did a meta, the UK health, um, uh, regulators did, did a meta analysis that where they argued that it's 90, at least 95% safer than, than cigarettes. Um, and so, um, I'm not super worried about that. Um, you know, we'll see, but, uh, it's, yeah, it's, I think

it's unknowable right now. No, look, it's a concern, right? Because again, the, the, all the tobacco guys, I mean, I can't remember if they went bankrupt or almost went bankrupt on these settlements, but they were big settlements, but ultimately they turned into huge margins and they kind of turned the government's your partner. You could imagine if it was like, hey, you know, we're selling these vapes for, pick your number, $5 a pack. It was, hey, a dollar per pat goes to the government. You could imagine how that actually spurs the government to be like, hey, we're really going to start cracking down on the non-regulated stuff because we don't get anything from them and we get a dollar from the regulated stuff. So you could see how that could turn it back into like

this great oligopoly. So it's just really interesting because most people think, taxes going up are bad. Yeah, in generally, rather than low. But you could see how that that could reintroduce huge barriers to entry here. Yeah, right. And spur regulation of the illicit of the products. Exactly. Exactly. Let's talk. I just want to briefly talk menthol cigarettes. You know, so you mentioned the California ban. US might ban it. I know in your note you've got the two models for 2006 menthol ban versus no ban. Just want to ask, look, what is the menthol cigarette ban. Why does it hit British Americans back a little bit harder than their peers? And how are you thinking about that risk? Yeah. So the menthol ban is a proposed countrywide. I almost said

worldwide, but we don't have worldwide bans on things just yet. Countrywide in the U.S. ban on menthol cigarettes that FDA is proposing. And they basically said a number of times, like, we are going to do this. Yep. And the reason why is because, Because, you know, any type of flavor, including menthol, in an addictive product, just makes it, I mean, it just makes it tastier. It just makes it more, you're more likely to get addicted. And there's some research that shows that, you know, the younger people are more likely to get addicted to menthol. And as someone's still trying to recover from the ice cream addiction of my college years, I completely understand tastier flavorers results in a lot more addiction. Yeah, you were talking about ice cream flavored Jules, or are you talking about actual ice cream?

Oh, actual ice cream. Oh, okay. And the menthol cigarettes are also disproportionately smoked by black Americans, which, so, you know, obviously any negative health impacts that come from those disproportionately affect that group. But so the FDA said, we're going to ban it. They said, we're going to ban it. And they push it back a few times. And it's a little bit, it's a little bit controversial.

Like some people are saying, some people say, well, it's from a health standpoint. it would be great for, you know, minorities in this country to have a ban on it because fewer people would smoke and fewer people would get cancer, et cetera. And then other people are like, well, yeah, maybe, but is this going to mean that, like, cops are going to be, like, you know, pulling over, like, black drivers and, like, seeing a menthol, like, cigarette pack in their, in their hand and, like, arresting them? Or, like, what actually is going to be the enforcement here? and kind of highlighting the potential for that to disproportionately affect black people in the U.S. And so it's a little bit controversial.

And my guess now is now that we're only, whatever we are, you know, eight months from the election, like, or nine months from the election, it seems likely to me that it gets pushed back past the election. And if it does, you know, who knows when it might get, when it might get implemented. but the ban would disproportionately affect VAT because, you know, like more than half of their U.S. revenues from menthol cigarettes from Newports. And so if you ban that, it makes, you know, if you ban something with $5 billion of revenue, it's just, you know, it's a tough situation to be in for a company with, you know, only a $28 billion or whatever, a revenue. And so the company has said that they would retain, they plan to retain, they plan to retain. you know, 80 plus percent or something of, uh, of that revenue through various means,

including by, including by, uh, rebranding it as like cool and crisp flavor or something, which they've done in California to try to get around the menthol ban. Wait, yeah. So how does that work? How does the like, I actually don't, I, I, you'd have to look it up. The, the, I don't think it actually has any flavor, but it's like, it like, like the packaging just says like cool and crisp Newport or something. And it has the same color. Okay, so you take the menthol out, but you just like kind of try to subliminally, not even subloom, like, I think they might, I think there might be, I think they might all, I think they might claim that like the way they make the tobacco makes it like cool or something,

but it's not actually flavored with menthol. I think, I think there's like some, I don't know, I haven't smoked it. So I couldn't tell you exactly. It's, it's like, you know, mint water where you put the mint tea leaves it like when they're brewing the when they're making these cigarettes they soak them in like just mints and it comes up mincy yeah no that's interesting let's see where else do i want to go but so yeah but i mean so it's a huge risk for them uh i think it's cheap enough that they could even if it's banned i think it's still probably cheap um but it looks to me like it's going to get pushed out and i doubt a trump administration doesn't bans it the okay so you mentioned right at the start, right, for years. Look, the best performing socks of the past 40, 50 years are the

spacko stocks, right? If you bought Altrio Phil Morris, whatever, in the early 1970s, like, you're listening to this from your own private beach. So I certainly understand that, but I do worry when you're looking and they're saying, hey, you know, now some of this was menthol, but we're talking about like double digit declines, volume declines in the U.S. in 2023, offset largely by price. And some of that was menthol again, but it normalized for that and it was probably 5 to 6% volume declines offset by price. I do start to worry at what point do you start doom looping on the legacy business, right? Because again, it's still 80%. And if it disappears 30 years from now, that's one thing. If it starts, you know, if those declines start

accelerating and I could paint you a picture where 10% pricing plus your user base dying, plus some of it switching, like it feels like we're getting there. I mean, I know, again, I've never smoked in my life, but I know people always complain about the cigarette prices are like a 5x in the past 10 years. Like, at what point do you start doom looping on just the prices you high, fixed cost, all that type of stuff? Yeah, that's a great question. It's unfortunately kind of unknowable. The company, what the company will say is if you look at, they actually talk about the affordability in the U.S. because our GDP per capita is so high. So if you look at like, if you look at like the price of a pack of cigarettes compared to like the, you know, the value of someone's time in the

US, like whether it's wages or GDP per capita. It's actually relatively low compared to other places in the world. So they're claiming that that gives them the ability to continue to increase prices. I have no idea if that's actually correct. And yeah, I'm pretty skeptical. I mean, we definitely, in our assumptions, we use much, we, I mean, I know some people in the comments, on Twitter said that some people in the comments on Twitter said that, you know, my assumptions look a little bit aggressive. I estimate a 5% volume decline across the entire business and a 3% price growth, so 2% net revenue declines in the traditional cigarettes business, which for the U.S. would be probably more because it's going to, it looks like it's going to decline faster than

in other places. To me, that feels pretty conservative. But yes, but especially against last year, maybe it maybe it's not because last year was a pretty bad year. I was just looking to the company took a goodwill write off in 2000, a big goodwill right off in 2023. And look, Goodwill is non-cash by the time. They're writing off. Trust me, the stock market almost always knows the Goodwill write-off. But I was just looking. It was interesting because this is a foreign company, not American company, when they do the Goodwill write-off, they disclose a lot of the assumptions behind the Goodwill write-off, and I was just kind of looking, you know, there's talking about Palmall, 19% five-year volume Kager declines, Newport, Camel,

11 to 12% volume Kager declines. Now, that's not talking about, there's no pricing there, and some of the brands are lower than that, but I was looking at that, I was like, oh, Jesus Christ, like, those are, those are, those are big five-year kegars, you know, so I just didn't know, that was, but as, as you know, we're paying seven times, eight times free cash-o for like you pay a rosy price for a rosy out look this is a pretty draconian price i don't know if you want to say anything about the goodwill write off yeah i i i don't have strong opinions on the goodwill write up i tend to i feel like those exercises tend to be uh you know obviously it's non-cash um i i don't put a ton of of stock into it but um but maybe it is reason to be

skeptical of their of their claim that like they like in their forecast they claim that like the traditional tobacco business is going to be flat. It's probably reason to be skeptical of that, I'd say. Let's talk about something else. So ITC, they own this big stake in Indian tobacco, ITC, it trades in India. And it's almost funny. We haven't mentioned it because when we were doing this, it's like the ITC, it's so value and so big.

I was like, is that actually what we should start with? But I don't know. I'll just flip whatever you do. Why don't you explain what the IT stake is, the value, like how you're thinking about that? So they, um, uh, so ITC is an Indian company that, um, it used to, it used to stand for, I believe, India tobacco company, but they rebranded as ITC. Um, it's a roughly, uh, 60 billion U.S. I think, uh, market cap company. Um, and BAT owns 29% of it. And so, you know, when you look at that, the value of that stake relative to the size of the market cap of, uh, of BAT, it, you know, it's like 25, 30 percent or something of the, of the, of the market

cap of BAT. And it doesn't really contribute that much to earnings. So they, they, because I, ITC trades at, you know, more than 20 times earnings, you have a situation where it certainly looks like they could return, you know, it's a non-strategic stake. Well, they, actually, that's not true. Long term, it may be a strategic stake, but it's not strategic in the sense that it's not directly helping their business right now in terms of, it has nothing to do with their business in the U.S. or Europe or elsewhere. So when you do the math on it, I mean, it really would change the enterprise value of the company. I mean, they could pay off, you know, more than half the debt with this, more than half of the net debt with this stake if they were able to sell it.

And recently on the last conference call, they said that they were going to sell a piece of it, you know, to kind of realize that some of that value. you. I mean, ITC is very interesting because they've been, you know, they've, they've been growing profits slowly until the last couple years, and then it's ramped up a little bit. It makes about, I mean, it's interesting because they pay a large dividend. So the dividends paid by ITC have gone from not to, not to BAT, but just in general, have gone from a billion in 2018 to two billion today. And that's annually. And they've still been growing through that period. So, you know, so BAT collects like five or six hundred million of dividends.

from them every year. And so, you know, if they were able to monitor, if you include it in their kind of enterprise value calculation, it makes the stock look really cheap. But the more, in my opinion, because they said they said they were going to sell a 4% stake of their 29%. And it's not really going to be that material. Yeah.

It was the, I mean, it's so interesting because they've got this big stake, right? And it's in a high multiple company. Now, I'm not, it's a high multiple company. I'm not saying that there's anything more to it than that. A lot of stuff in India trades for a lot of higher multiple. But the two interesting, the three interesting angles that were, hey, we own 29%. We think it's strategic enough. We need to keep it above 25.

So we're going to sell off this 4% stake. It was very strange to me. The other thing was I saw a lot of people. And I kind of agree with this. Like, it's a high multiple stock, your low multiple stock. I saw this in the Spack boom days, right? Once you start talking about selling down part of the stake, the stock gets hit. And it's like, hey, you're going against yourself.

But I know, I was kind of curious. just how are you thinking about that valuation within and also I guess the last part taxes because if I remember correctly this is a they basically funded this business I think they said they've been involved for 90 years so I'm guessing their tax basis rounds to zero like if they did something should we be taking a huge tax effect on it yeah that's that's that's a good point I'm not actually sure what the what the tax effect would be that's probably because I've just kind of always assumed that they weren't going to be able to sell it and now like you know kind of the effect on the enterprise value is not really real because they could never monetize it.

But the way I account for it is I just assume that their dividends from ITC are going to go from, you know, 500 pounds a year to, you know, maybe six or 700 pounds per year over the next, you know, five years, which for the multiple of 25 times earnings to make any sense, it probably needs to, right? Like, probably they need, and they have been growing and they have been growing. So it makes a little bit of sense that way. Um, but, uh, yeah, so that's kind of how I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I, I think, so vapes are, are, are, are not allowed to be sold in, uh, in India right now. Um, but it's interesting to think about if there could be some type of partnership longer term, um, to actually, you know, because you have a billion, a billion, a billion whatever people, a lot of whom smoke. And, and, you know, there's not really a good reason. and why the government shouldn't allow vapes into the country long-term.

And so I don't know. I think the more interesting maybe long-term result is some type of partnership where they are able to grow an Indian business, maybe if it's just selling to ITC to kind of use their vaping assets in that way. Just the way you talked about ICC, would I be crazy if I said, obviously you're ascribing some value to BAT's ITC stake, but you're not describing kind of the market price of ICC to exactly yeah i think that's right yeah so so i'm growing the dividends in my model i'm growing the dividends that they get from them but i'm not like i'm not like subtracting the

enterprise value from the current price or or subtracting the market cap of their stake in ITC from the current enterprise value or anything like that and and i and for me it might happen long in some time later but in terms of monetizing that stake but i i don't think it's needed to think that BAT is true. It's interesting because, you know, I think one of, I have had historically very little success with some of the parts stories with one exception. And I think the exception is when you've got a, let's call it a legacy company that's trading for a very low multiple and they've got a stake in a very high multiple company. And like one I think about when I just pops to mind, hadn't thought about more of the podcast, but one that pops to mind, which I think you were

involved with two is Dell with their VMware stake, right? Del legacy Dell oftentimes, you could buy them for free for one times PE if you were looking through the VMware stake. And there were lots of debates. I mean, I think people rightly or wrongly were saying, hey, part of the reason that this exists is because people do not trust Michael Dell. But that worked out, that trade just worked out absolutely swimmingly. And did Michael Dell get more than his fair share of the profits of that trade? I would argue absolutely yes. But, you know, it actually worked out really well for everyone, especially if you held through the, if you held all the VMW stock, because they merged with Tobago, or sorry, with Broadcom, ticker AVGO, and AVGO stock went up like 4X in between

the merger announcement and the deal closing. So that was just a grand slam home run. But yeah, I don't know. I, off the top of my head, I can't think of any examples, but I think that's the one place that's really worked. And I'm just, as we're talking it through, I'm just seeing bats seven times the ITC, huge stake, 33% of equity cap. Like, that's just this pattern matches. My view is that actually, my view is that some of the parts get a bad rap, because they're usually done so terribly. And I don't think it actually indicts that method of analysis. It's just that what most people do is they take four businesses with four segments with

like four different EBITDAs. They slap multiples on. They're like, oh, this is worth 12, this is worth 8, this is worth 15, and this is worth seven. And then they try to get an enterprise value number from that, not considering that like all of those multiples need to be a need to be. justified, then you're not even thinking about like, well, how does that convert to free cash flow, you know, what are the CAPX needs, et cetera, of each of those businesses. And so you get this

some of the parts number that makes no sense. And then, you know, you have a bad investment analysis, in my opinion. Where I think some of the parts can go well is if the some of the parts has to be in addition to something else that's going on. So it's in addition to a core, free cash flow growth IRR story that exists like you have with BAT then I mean then like this other part that's not getting valued is just like the cherry on top right

and and so that that's kind of how I view it like the some of the parts has to kind of confirm what you already suspect about the DCF value and in those cases it it can work but

otherwise and it just all that that means is if you're going to slap 20 times EBITDA on some segment, you need to show me how the free cash flow growth in that segment is going to justify a 20 times EBITDA multiple. You know what I mean? So I do, I do hear you. I think to me, it's hard for me because like, let's just use Comcast, right? Comcast, let's simplify it two segments, a media segment and a cable segment. And I think a lot of people look at and say media, let's pick media worth 10, cable worth five, put it together. That's your enterprise value. And I think that's actually technically correct, right?

I think the two things that, to me, get missed most often is they forget about the corporate overhead. You know, everybody loves to present the sum of the parts and everybody always forgets about the corporate overhead. And I chose Comcast for a specific reason on the fly. And that's because they also forget about the conglomerate discount, right? Where, you know, a Comcast, everybody is terrified of the next deal Brian Roberts is going to do. And Brian Roberts controls that with a pretty iron fist. And, you know, I know you had a lot of success with, I kicking myself, meta in November 22, right? And I think part of that success is it was crazy cheap, but people forget November 2020, I do think people did think some of the business was terminal. They were worried about the spending on Meadow Labs.

But a lot of it was Mark Zucker, people were playing a huge conglomerate discount on Mark Zuckerberg because he controlled it. And people were worried he was going to increase spending on Medi Labs from $16 billion to $160 billion or something, right? And I think people forget, like a big part of it is the conglomerate discount. And a lot of some of the parts can be getting the conglomerate discount taken away, getting the, in Michael Dell's case, in Meta's case, getting the conglomerate discount that maybe is partly rightly signed, but it's way overblown, or it's about to get removed,

it's about to change, and Mark Zucker's case is going to go to a premium again. Like, I'm just rambling, but that's kind of my. Yeah, I think, I think, um, I think that type of story can work even, uh, I think it can work when you properly analyze the individual segments and you don't mess up the corporate overhead.

And that's one of the reasons why I force myself to bring it down to free cash flow at the enterprise level because you can't that that way you won't you don't miss things like that um and and then and then if you are long something that has that conglomerate discount and you but you do still believe in the free cash flow forecasts you're you're just constantly long an option that the guy's not an idiot right like you're constantly long an option that Zuckerberg wakes up and says wait a second why am i growing expenses 30% when my business is stagnant this year. Like maybe I should cut some employees. Maybe they don't all need to get lattes for two hours in the afternoon and we can just have everyone work from nine to five.

Like, you know what I mean? And so you're constantly long that option or actually one that worked for us was Fox back in the day. And that was a sum of the part story, but you could, but you could, um, you could pencil it out in terms of free cash flow. Like they, they really did have they really did have some some growthier segments that that deserved a decent multiple and you were long an option that Rupert Murdoch decided to do something smart and you know in that case the option the option paid off you are you are the one man to have made money on the Fox stock if that is the case because it's always got that some of the parts it always looks cheap and it is this is the pre the pre the pre Disney sale Fox

obviously. Oh, okay. Okay. Okay. I was thinking fine. No, that's a great point. And look, Rupert Murdoch, God, that was quite the bitty more too. Uh, Rupert Murdoch finally got religion on that. Like all the best investors, Fundamental Edge believes that the learning process never truly ends. That's why the Analyst Academy is just the beginning of their journey with you. Fundamental Edge alumni gain access to exclusive content, such as their guest speaker series. It recently featured TEDCDs of capital allocators. Alumni can also look forward to frequent webinars, case studies, and content from industry partner. For job seekers, there's the talent hub, which helps both academy graduates and other byside candidates connect with top

funds looking to add new analysts. Alumni, including students enrolled in the upcoming January cohort, are also invited to the inaugural analyst spring training conference coming up this spring in Scottsdale, Arizona. Attendees will engage in numerous learning sessions while building their byside networks, and then they'll enjoy some spring league baseball and the amazing Arizona weather. If you'd like access to all that fundamental edge has to offer your your career, visit Fundamentedge.com for more information about the next academy cohort. That's Fundamentedge.com. Let me just ask one last question, turning it back to bats.

Huge free cash flow, pay out a ton of dividends. However, I think they've also been kind of clear that they want to do some strategic acquisitions. They might want to buy some brands and that type of stuff. And when I see tobacco companies saying I want to do anything other than return capital to my shareholders, I get a little bit nervous because I think the. history of tobacco company is they produce unbelievable cash flows, right? If they return it to shareholders, you're going to do great. If they go buy a, you know, if the number three company buys the number four company synergies out the wazoo, you're going to do great. Anything else

and it's going to be a disaster. And anything else can be Philip Morris invested in Jewell at the absolute top of the market. Anything else could be in the 80s, all these tobacco guys saying, we've got tons of cash flows. Let's go buy RJR and Nabisco. Let's go buy movie studios. You know, like you can look at but anything else now they're saying they want to do strategic stuff and I think if I had to guess 80% plus a free cash was going to be returned to shareholder so maybe I'm seeing my own shadow here but just want to ask you like how company do you feel because when you're buying something at less than 10x free cash flow a lot of it is just the the free cash flow return story than anything else so how company do you feel with all that yeah I mean that is the one

nice thing about a dividend is even if it's not completely economically rational that the companies feel pretty tied to continuing it and growing it over time. So like you said, that, you know, that basically accounts for, you know, it's probably, you know, 60 plus 60 to 70 percent of their, of their free cash flow. And yeah, I mean, if you told me that they were going to take the rest of it and go buy, really do any acquisitions, I really don't want them to do acquisitions. You're probably unsurprised to hear me say. That would definitely ding my forecast somewhat. because, you know, I think they should probably, you know, they can get, they can get like risk-free, you know, 6% roughly by just buying back their debt or just, you know, or paying

down their debt as it comes due. So, you know, that would be the other thing that I would want them to do with the money. And they have talked about doing that as well. But yeah, please, please don't let them do anything stupid. Isn't it crazy how the world changes just, you know, two years ago? I mean, a lot of their debt is fixed cost. So one of the funny things is, this or a lot of the big companies that are, you know, maybe their stock prices are down over the past two years. A lot of people look at him and say, oh, they've got debt trading for 60 cents on the dollar.

They're in distress. It's like, no, dude, they issued 25 year debt at 2%. Like, it's trading that 60 cents on the dollar because they did a great job. But it's just so funny. Two years ago, you and I would have never said, hey, taking cash flow to pay down risk-free debt is a good idea. But today, I mean, I think it would probably be better as the shareholders to dip in the out and just return it to them.

But it's an argument, right? You lengthen the runway, lower that interest burden. Taxes across the board have probably come down, so you don't get as much of a tax show from them anymore. But cool. Cool. Evan, anything else you want to talk about with British American Tobacco? No, that's it.

Yeah. I think this is, we pretty much ran the gamut on this thing. You know, as I'm thinking of it, I think this is actually your fourth podcast appearance, and I said third at the start. And, you know, fifth podcast appearance, you get the yet another value blog t-shirt. Oh, okay, okay.

All right, I'll have to come up with more good ideas and, or more, I don't know if they're good, but ideas. Just more ideas. I've got ideas. I've got ideas. Well, look, the British American Tobacco write-up is fantastic. There's going to be a link in the show notes. So I would encourage anybody who wants to read a really good write-up to follow that,

reach out to Evan. Evan, I'm looking forward to the fifth podcast. You're going to get a shirt from it. I'm going to wear my hat, wear your hat for it. So we'll go from there. But Evan, thanks so much for coming on. Looking forward to chatting soon. Thanks, same to you.

A quick disclaimer. Nothing on this podcast should be considered an investment advice. Guests or the host may have positions in any of the stocks mentioned during this podcast. Please do your own work and consult a financial advisor. Thanks.