Equity Research British American Tobacco

Equity Research British American Tobacco

•CURIC• Authors

ABEDIN Murtaza Salman YIP Daria Yong-Tong MALHOTRA Samya

AKHMELVAN Gerald WIDJAJA Raymond

LAI, Timothy CHEUNG, Austin

Contributors QUTAISH Pichaporn

THE FINAL PAGE OF THIS REPORT CONTAINS A DETAILED DISCLAIMER The content and opinions in this report are written by university students from the CityU Student Research & Investment Club, and thus are for reference only. Investors are fully responsible for their investment decisions. CityU Student Research & Investment Club is not responsible for any direct or indirect loss resulting from investments referenced to this report. The opinions in this report constitute the opinion of the CityU Student Research & Investment Club and do not constitute the opinion of the City University of Hong Kong nor any governing or student body or department under the University.

Rating Buy Price (08/04/2020 GBP) 29.62

April 8th, 2020 Europe

Target price (GBP)

% up from Price on 08/04/2020

38.39

29.61% Equity Research Market cap. (GBP, Billions) 67.95 Enterprise Value (GBP, Billions) 140.25

Stock ratings are relative to the coverage universe in each analyst's or each team's

respective sector. Target price is for 12 months.

Research Analysts:

Murtaza Salman Abedin +852 59858568

[email protected]

Gerald Akhmelvan [email protected]

Samya Malhotra

[email protected]

Timothy Lai Tsz Long [email protected]

Raymond Widjaja

[email protected]

Cheung Yue Tseung [email protected]

Daria Yong-Tong Yip

[email protected]

Contributors Pichapon Qutaish

[email protected]

Tobacco

British American Tobacco PLC. (BATS:LN)

Our Analysis of British American Tobacco PLC. hereupon referred to as “British American Tobacco PLC”, “British American Tobacco”, “BATS”, or “BAT” has been driven by a number of modelling approaches, including DCF (Discounted cash flow), Comparable Company Analysis (CCA), and M&A precedent transaction analysis. Our valuations give ‘BATS’ a fair share value of GBP38.39 with a (BUY) recommendation and this has been calculated through the valuation of the 5-Year forecast period ranging from the years ending 31st December 2020E to 2024E.

British American Tobacco is a long time key player that manufactures, markets, and sells cigarettes and other tobacco products. It is the second-largest publicly trading tobacco company by market share. Their brands are sold in over 200 markets in the world, with high exposure to emerging and frontier markets. BATS owns brands including Camel and Lucky Strike. The sector in general, is challenged with further regulatory initiatives and changes in consumer behaviour.

Minimal revenue impact from (COVID-19) pandemic:

Our research, further supported by a Bain&Co analysis, has indicated that smokers are likely to keep smoking through the coronavirus outbreak even during home quarantines. The cigarette demand stays stable amid the outbreak, and BAT is supported by a geographically diversified supply chain. The impacts of COVID-19 on tobacco companies are, therefore, minimal. BATS has joined the race to develop a potential vaccine for COVID-19 using tobacco plants.

Attractive dividend yield:

BAT’s high dividend yield of 6.72% (Trailing Twelve Months, data by Reuters) is attractive to investors. Even though the earnings growth may decelerate to low- single-digits, it is believed that the stable earnings and cash flow will be able to continue to cover their dividend payments. The company has not missed a single dividend payment in over 20 years.

Steady deleveraging phase :

BATS continues to focus on a balanced approach of deleveraging. The strong operational performance and cash generation drive deleveraging of the balance sheet. Their net debt to EBITDA ratio has improved from 6.22x in 2017 to 4.08x in 2019. Their strategy of deleveraging is expected to continue in being successful.

Further accelerate the growth of “New Category”:

It has simplified its “New Category” product portfolio with three global brands - VUSE for vapour products, VELO for modern oral products, and Glo for tobacco heating products. This has created more trusted international brands.

Copyright © CityU Student Research & Investment Club 4

Table of Contents

1 Company Overview .......................................................................... 6 1.1 Brand Overview ................................................................................................................... 6

1.2 Review of Last Fiscal Quarter ............................................................................................... 6

2 Revenue Analysis ............................................................................ 7 2.1 BAT Revenue Growth Rates in Regions ................................................................................. 7

2.2 Revenue Breakdown in Terms of Product Categories ........................................................... 8

2.3 BAT Revenue by Income Demographic ................................................................................. 8

2.4 Additional Key Revenue Drivers ........................................................................................... 9

3 Industry Overview ............................................................................... 10 3.1 Tobacco Industry’s Demographic Shift ............................................................................... 11

3.2 United States’ Spike in Vaping Related Lung Injuries .......................................................... 12

4 Competitor Analysis ............................................................................. 13 4.1 Philip Morris International (PMI) ....................................................................................... 13

4.2 Imperial Brands (IMB) ........................................................................................................ 14

4.3 Altria Group (MO) .............................................................................................................. 14

4.4 Japan Tobacco International (JTI) ....................................................................................... 14

5 Valuation .......................................................................................... 15 5.1 DCF: Discounted Cash Flow Model ..................................................................................... 16

5.2 M&A Precedent Transaction Analysis Model ...................................................................... 17

5.3 Comps: Comparable Company Analysis Model ................................................................... 18

5.4 Enterprise Value Multiples Approach (EV/EBITDA and EV/Revenue) .................................. 19

5.5 Price to Earnings Approach (P/E Multiple) .......................................................................... 20

5.6 Price to Book Value Approach (P/B Multiple) ..................................................................... 20

6 Growth Opportunities & Market Catalysts ................................................... 20 6.1 New R&D under BAT .......................................................................................................... 20

6.2 M&A Activity Historical Analysis ........................................................................................ 22

7 Corporate Policy and ESG ...................................................................... 25 7.1 Environmental laws’ impact on businesses ........................................................................ 25

7.2 Company corporate policy on the environment ................................................................. 25

7.3 ESG Score breakdown ........................................................................................................ 26


7.4 Company Ownership Structure .......................................................................................... 28

7.5 BAT’s Expansion Scheme .................................................................................................... 28

8 Investment Risks ................................................................................. 28 8.1 COVID-19 Disruptions and Macroeconomic Risks ............................................................... 29

8.2 Systematic risks ................................................................................................................. 29

8.3 COVID-19 Potential Vaccine ............................................................................................... 30

9 Appendix .......................................................................................... 31 9.1 Appendix 1. Income Statement .......................................................................................... 31

9.2 Appendix 2. Balance Sheet ................................................................................................. 32

9.3 Appendix 3. Statement of Cash Flows ................................................................................ 33

9.4 Appendix 4. Comparable Company Analysis Model ............................................................ 34


Company Overview

Brand Overview

British American Tobacco is a cigarette and tobacco manufacturing company, founded in 1902

when the Imperial Tobacco Company and American Tobacco Company formed a joint venture,

headquartered in London, United Kingdom. The company has acquired a few major tobacco

brands in the late 1990s, which turned out to be their largest selling brands.

Its cigarette and tobacco heating product volume has reached 677 billion units in 2019 and 226

million units for vapour products. The group has a total of 14 strategic brands, including but not

limited to, Dunhill, Lucky Strike, and international brands such as Vogue and Shuang Xi. It has

operations in around 180 countries and productions in 45 factories spread among 43 countries.

There are also over 11 million points of sales with an employee base of 53,000.

British American Tobacco historically focuses on the powerful brands they built and on the priority

markets with high growth segments. It is also a long-sighted company which consistently evolves

strategy and seeks to improve their research and development. Currently, they focus on broadening

their portfolio by developing new products to meet customer needs and continuing their social

responsibilities.

Review of Last Fiscal Quarter

In 2018, BAT’s revenue grew by 25.2% at GBP24,492 million largely due to the Reynolds

American Inc. (RAI) acquisition. As of 2019, British American Tobacco has seen a 6% revenue

growth of GBP1.4 billion , leading to a total of GBP25.9 billion in 2019.

They have simultaneously increased their investments in the business, like their New Categories

products, resulting in a growth of 37% in revenue in 2019. They are focusing on maximizing cash

to reduce their leverage and invest more in the business.

Their focus for 2023-2024 lies in increasing the transition of their revenue from cigarettes to a

higher volume of non-combustible products over time. They have remained committed to a

sustainable long-term revenue growth of 3-5%.


However, improvements in revenue and operational efficiencies were offset by smoking and health

litigations. This has resulted in the decrease of profit from operations by 3.2%. Dividends saw a

per share increase of 3.6% from 2018 to 2019. The basic EPS for 2019 was 5.4% lower than 2018,

mainly due to the reduction in the profit from their operations.

Figure 1: Property of CityU Research & Investment Club

Revenue Analysis

BAT Revenue Growth Rates in Regions

According to the Preliminary Report 2019, the United States (US) region has realized a revenue

of GBP9,134.49 million, the Asia Pacific and Middle East (APME) region has realized a revenue

of GBP4,537.74 million, the Americas and Sub-Saharan Africa (AMSSA) region has realized a

revenue of GBP3,752.25 million, and the ENA (Europe and North Africa) region has realized a

revenue of GBP5,362.87 million, contributing to a total of GBP22,787.34 million. From 2018,

US region's revenue rose by 9.2%, APME region's revenue rose by 5.6%, AMSSA region's revenue

rose by 3.6%, and ENA region's revenue rose by 1.4%.


Revenue Breakdown in Terms of Product Categories

By categories (Combustibles, New Categories, Traditional Oral, Other), a large part of the revenue

comes from Combustibles, approximately worth 88.85%. New Categories makes up 4.85%, the

Traditional Oral makes up 4.18%, and others make up 2.09%.


BAT Revenue by Income Demographic

While BAT does not specifically mention their customer profiles and income demographic, based

on their volumes per country and average income, one can deduce the average wealth of the

country and the market potential. We have identified key countries and their respective average

income per capita, then calculated each region’s average income per capita based on the key

countries. The averages are GBP10,616.14 million for AMSSA, GBP16,416.46 million for

APME, GBP23,436.84 for ENA, and GBP51,409.94 for the US. Especially for ENA’s region,

which has a high number of countries with a large range of values, its average may be skewed

more towards one way.

Based on these figures, we can see that generally, the US has the largest gross income and has

most likely, more disposable income to spend on cigarettes. The revenues from the higher income

demographic come from the US with GBP9,134.49 million, then ENA with GBP5,362.87


millions, APME with GBP4,537.74 million, and AMSSA with GBP3,752.25 million. For BAT,

since their volumes are the highest for cigarettes in the ENA region (in billions of sticks) with 231,

then APME with 221, AMSSA with 152, and US with 73, it seems that the volume and low price

point products would be the main drivers in the ENA and APME, and the AMSSA could be a mix

of the volume and price drivers for revenue. However, the US is most likely to have a high price

point that makes up for the lack of volume.


Additional Key Revenue Drivers

South Korea and Japan have become key markets in the performance of Glo, their tobacco

heating product (THP). However, their preliminary report mentions that this was partially offset

by dropping volumes in the Middle East. According to the report, this is largely due to “the

impact of 2017 excise-led price increase in Saudi Arabia and the difficult trading environment in

a number of countries in the Middle East.”

An interesting point to note is their falling revenues in the recalibrated regions. The APME

category has dropped from GBP4,379.24 to GBP4,299.10 million in 2018; AMSSA has also

dropped from GBP3,806.84 to GBP3,620.16 million in 2018; and ENA has dropped from


GBP5,378.72 to GBP5,287.14 million in 2018. While there may be different reasons for the

recalibration of regional revenue categories, it is most certainly a show of how important the US’s

revenues have become to BAT since 2017, after the Reynolds acquisition.

Industry Overview

As of 2018, the tobacco industry is worth GBP651.2 billion and its industry profit pool is

projected to grow at a rate of 5% CAGR for the next 5 years starting from 2020 (JPMorgan). The

demographic of this industry has changed considerably and inverted in the past years, as prevalent

use of tobacco and cigarettes shifted from developed to developing countries. According to the

World Health Organization, around 80% of smokers globally live in low and middle income

countries. Cigarette consumption amongst the youth is also on the rise as tobacco companies have

introduced flavoured cigarettes and e-cigarettes which may appeal to the youth. With the recent

trend of consumers becoming more health conscious and aware in this decade, combustible and

traditional cigarette consumptions have seen a decline. Companies have responded by diversifying

their product portfolio to include Potentially Reduced-Risk Products (PRRPs) such as Vapour,

Tobacco Heating products and Snus which have all been on the rise and have exhibited rapid

growth as these are perceived as an alternative to cigarettes and have helped people to stop

smoking. The tobacco industry is one of the most profitable industries in the world, due to their

control and power over the prices they set, stemming from tobacco’s inherently addictive nature

under the presence of nicotine.

The five biggest companies of the tobacco industry include British American Tobacco (BAT),

Philip Morris International (PMI), China National Tobacco Corporation (CNTC), Imperial Brands

(IMB) and Japan Tobacco International (JTI). Each of these companies have large market shares

globally in various regions, except in some countries such as China where CTNC enjoys a

monopoly from being state-owned. Merger and acquisitions (M&As) have been a prevailing trend

and a preferred method of expansion in this industry where the previously mentioned companies

often acquire tobacco companies operating in various markets to ease the market penetration

process. One of the major M&A transactions include Philip Morris’ acquisition of Indonesia’s HM

Sampoerna (92.5% stake) in 2005 where it has a market share of 30.2% in Indonesia as of 2018.



Tobacco Industry’s Demographic Shift These changes may be attributed to higher economic growth of developing countries, resulting in

rising incomes. Laxer government regulations and policies on tobacco companies is another strong

reason as to why there is a shift. An interesting feature of most of the markets that are in the

developing region is the sale of single cigarettes that enable people who cannot afford one whole

pack to buy. For example, one third of a pack. As of the end of 2018, the five largest markets for

cigarette consumption are China, Indonesia, United States, Russia and Japan. Governments of

developing countries are facing a dilemma

concerning a potentially huge trade-off:

tobacco companies contribute a sizable

portion of tax revenue to the government,

versus, whether they should be more closely

regulated and more heavily legislated, where

people’s health will be improved but at the

expense of economic loss ensuing.


Largest Cigarette Markets by Volume

Country Retail Volume 2018 (Billion sticks) China 2368,7

Indonesia* 307,1 USA 240,9

Russia 236,5 Japan 132,7

*excluding hand-rolled kreteks

Source: Euromonitor



Source: Euromonitor

United States’ Spike in Vaping Related Lung Injuries Around August 2019, there was an outbreak and a sharp increase of over 2,700 pulmonary injury

cases that was related to vaping and electronic cigarettes which have brought the spotlight to the

industry. JUUL’s product image was damaged the most, which brought negative sentiments from

the public that led to a drastic decrease in Altria Group’s (having a 35% stake in JUUL) share price

by -14.5% and their sales by 26% in two months. In January 2020, the Food and Drug

Administration in the United States increased the minimum legal age to 21 for buying tobacco

products (cigarettes, cigars, e-cigarettes). This may prove to be a potential headwind for the major

tobacco companies, as the United States is one of the tobacco industry’s largest consumer markets.

Furthermore, there is a risk that tobacco companies may be subject to more regulation and

restrictions from the U.S. government, which may threaten their sales.


Competitor Analysis

Market Revenue Debt to 5 Year Share Cap (GBP EBITDA Equity Price (GBP Billions) Margin (x) FY Performance1 Billions) FY2019 FY2019 P/E (x) 20192

Name of Company (Ticker)

British American Tobacco (BATS.LSE) -15,92% 61,44 25,88 40,69% 10,76 0,7 Philip Morris International (PM.NYSE) -10,55% 98,95 23,84 38,60% 17,22 negative Altria Group (MO.NYSE) -19,82% 59,57 15,84 53,30% negative 4,51 Imperial Brands (IMB.LSE) -50,52% 15,69 16,2 22% 14,51 2,76 Japan Tobacco International (2914.TSE) -44,50% 26,36 15,9 31,50% 9,35 0,366

Average

-28,26%

52,40

19,53

37,22%

12,64

1,73


In this section, we highlight BAT’s main competitors (also known as Big Tobacco) and give a

general overview of their business and a quick summary for some companies, recapitulating their

performance or events that happened during the most recent fiscal year. The table above denotes

some metrics that allow comparison between these companies.

Philip Morris International (PMI)

This tobacco company is renowned for their Marlboro cigarettes and their recent rollout of IQOS,

their newest THP product. PMI was in talks about a merger with Altria, however backed out amidst

the controversy surrounding Altria from their JUUL case. Highlights and strengths include their

introduction of IQOS to the Japanese market, where vape juice (the liquid in e-cigarettes) is

regulated similarly to pharmaceutical products, which made IQOS the only legal PRRP. They have

seen the best results in terms of 5-year share price performance. As per their 2018 annual report,

PMI has an international market share of 15.3%.

1 As of 10/04/2020

2As a cautionary note, the table above indicates that BAT has a low debt to equity compared to its peers, however, in this report we

have mentioned that they are in fact, levered and have high levels of debt after using additional ratios. The reason for their low debt

to equity is explained in our Comparable Company Analysis.


Imperial Brands (IMB)

Imperial Brands has one of the least favourable performance in terms of share price movement

over the past 5 years. The table indicates most of the share prices of the tobacco companies have

been declining, which may be caused by a tougher operating environment and negative publicities

surrounding the tobacco industry. Imperial Brands has one of the highest debt to equity compared

to the other companies. Therefore, despite similar conditions their inflated debt to equity ratio may

have triggered selloffs that have reduced their share price significantly. Comparatively, Altria has

a better market position and introduced JUUL which may explain why their shares did not drop as

much (before the spike in lung injuries) as IMB despite having a higher debt to equity. They are

the pioneers of leading vapor product, Blu.

Altria Group (MO)

Altria Group is the parent company of Philip Morris but has split in 2008. Altria handles and

operates in the US while PMI sells their products internationally. Therefore, Altria also has the

right to sell IQOS but only in the US. Altria had a rough recent fiscal year where their product,

JUUL, has received massive public backlash and resentment, accused of targeting the youth to

start smoking vapor and tobacco heating products which have strongly been linked to causing the

pulmonary injuries that were on the rise in September 2019. Legal costs have caused their bottom

lines to be negative in their recent fiscal year.

Japan Tobacco International (JTI)

This state-owned company mainly engages in tobacco manufacturing and sale, however, has 4

very distinct segments. They have their tobacco segment (domestic and international), medical

segment that engages in research and development of medical drugs, and food segment where they

manufacture frozen food, seasonings and have their own bakery.


Valuation

Our GBP 38.39 or GBX 3,839 valuation of British American Tobacco are derived from a weighted

average price target that was calculated through three valuation modelling approaches. Approaches

include a Discounted Cash Flow model, a M&A Precedent Transaction-Based Analysis, and a

Comparable Company Analysis. The DCF model was given the highest weightage of 50% because

of its increased complexity and incorporation of the most realistic forecasting and assumptions.

The other two are each given a 25% weightage to thus get a price target that has factored in a more

diversified set of assumptions and approaches. A combination of DCF, M&A Precedent

Transactions and Comparable Company Analysis has showed that BATS is relatively undervalued

as compared to their peers and cash flow projection even though analysts have seen significant

upside.


Weighted Average Target Price for British American Tobacco

Valuation Methods : Price Target Weightages Discounted Cash Flow Model £39.94 50% M&A Precedant transactions £46.03 25% Comparable company analysis £27.65 25%

Weighted Average Price Target :

£38.39


Our valuation analysis covers in detail the workings and assumptions for each of these models

and a demonstration of how each of these price targets have been generated.

DCF: Discounted Cash Flow Model

British American Tobacco DCF Valuation summary

UK 10 year Bond (risk free rate) 0.68% CAPM Cost of Equity 7.5% Tax rate 17.0% After Tax Cost of Debt 3.25% WACC 6.6% Perpetual growth rate (Post 2022) 0.7%

Terminal value 163,804

Enterprise Value 152,971

Equity Value (Market Cap) 91,622

Diluted Shares outstanding 2,294

Fair Value Share Price £39.94


Free Cashflow Valuation E

(GBP in Millions of British Pound except per share amounts) 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Total Revenues 13,104 14,130 19,564 24,492 25,877 25,380 27,209 27,780 28,363 29,214 Less Total COGS + SG&A (8,547) (9,475) (13,152) (15,179) (16,861) (15,449) (16,311) (16,525) (16,816) (17,283)

Total EBIT 4,557 4,655 6,412 9,313 9,016 9,931 10,898 11,256 11,548 11,931 Less: Tax (EBIT * Tax Rate) (1,333) (1,406) 8,129 (2,141) (2,063) (2,207) (2,454) (2,541) (2,647) (2,751)

Less: Capital Expenditures (601) (674) (978) (943) (815) (1,296) (1,080) (950) (900) (875)

Add: D&A & Non-Cash Expenses (income statement) 428 607 902 1,038 1,512 1,140 950 836 792 770 Change in working capital and other (cashflow statement) -445 305 2,142 2,035 1,875 -3,167 -1,656 3,955 -3,379 555

Free cash flows to the firm (FCFF) 2,606 3,487 16,607 9,302 9,525 4,402 6,659 12,556 5,414 9,630 Years to discount 0.75 1.75 2.75 3.75 4.75 Cost of capital 6.6% 6.6% 6.6% 6.6% 6.6% Discount factor 0.95 0.89 0.84 0.79 0.74

PV Free Cash Flows to the Firm (FCFF) 4,195 5,953 10,531 4,260 7,109


Our DCF valuation of British American Tobacco ‘BAT’ gives us an implied share price of GBP39.94 ,

which is also equivalent to 3,994 GBX for the forecast period ranging from FY 2020E-2024E. The revenue

projections in our model have been driven primarily by relatively stable industry trends and an inelastic

consumer base.

The WACC has been estimated to be approximately 6.6% as reflected by low yields on the 10 & 20 year


British treasury bonds. Additionally we have assumed a perpetual growth rate of 0.7% post our valuation


forecast, keeping in line with the global and regional tobacco industry trends and analyst forecasts. Our

capital expenditures have been forecasted in accordance with the expected company direction and realistic

market conditions.

M&A Precedent Transaction Analysis Model:

Our M&A precedent transaction analysis-based valuation of British American Tobacco gives us

an implied share price of GBP46.03 also equivalent to 4,603 GBX. British American Tobacco

(BATS) is trading at 9.9x EV/EBITDA and 4.02x EV/Revenue (an approximate 25% discount to

peers with an average EV/EBITDA of 12.4x and approximately 22% discount to peers with an

average EV/Revenue of 4.9x). Our March-28 target price of GBP46.031 is obtained by applying

a weightage of 30% EV/EBITDA valuation of GBP50.02 and 70% for their EV/Revenue

valuation of GBP44.33, given that BAT’s capital expenditures spending is considered significant

for this estimate. BAT’s buy rating is mainly due to the stronger acceleration of 2019 cigarettes

and oral sales in the emerging markets. We expect operational revenue growth annually to be

supported by constant deleveraging of the balance sheet to 3x Net DEBT/EBITDA by 2025.


The M&A transactions show significant revenue multiples being paid for Tobacco producers as

they continue to expand into other markets. The industry transactions in recent years have

primarily focused on tobacco, cigarettes (including e-cigarettes), and progresses toward the global

cannabis industry which has high growth potential and valuation multiples.



Comps: Comparable Company Analysis Model

Our Comparable Company Analysis based valuation of British American Tobacco gives us an implied

share price of GBP27.653, which is also equivalent to 2,765 GBX. In our Comparable Company Analysis,

we found the implied share price of British American Tobacco based on a weighted average of the price

target generated from four multiples. We compared BAT with the major players of the tobacco industry

along with some smaller-sized tobacco companies, and with 3 prominent indexes (S&P 500, FTSE 100,

MSCI ACWI) to broaden our comparison outside the tobacco industry and benchmark BAT against

reputable firms that constitute the indexes. Our model is pictured in appendix 4.

3 This model was done as of 23/03/2020. BAT’s closing price as of this date was 23.82 GBP.

Inc. United Dhaka

Ltd

Reynolds American

Inc.

UST LLC

EV/EBITDA


Comparable Company Analysis Price Target

Valuation Methods : Price Target Weightages Price to Earnings (P/E) £32.91 35% Price to Book (P/B) £35.58 35% Enterprise Value to Revenue (EV/Revenue) £8.95 15% Enterprise Value to EBITDA (EV/EBITDA) £15.59 15%

Weighted Average Price Target :

£27.65


Enterprise Value Multiples Approach (EV/EBITDA and EV/Revenue)

It could be seen in our model that BAT has a higher EV/EBITDA and EV/Revenue multiple (9.9x

and 4.02x respectively) than the median (7.5x and 2.5x respectively). This may imply that BAT is

overvalued, and we decided that it is best to use these metrics in conjunction to another ratio

namely the Levered Free Cash Flow4 (LFCF) yield5, because the LFCF is not capital neutral and

takes into account the free cash flow available after all debt repayments. In our calculation of each

firms’ LFCF, we assume that they do not have access to external debt. BAT’s LFCF yield of 1.8%

falls short of the median of 2.3%. Through this, it is given that BAT has high levels of debt and

lots of debt repayment. However, if we look at their Net Debt6 to EBITDA, we can see that they

have been continuously deleveraging (2017: 6.22x, 2019: 4.08x) and their EBITDA to Interest is

still at a healthy 6.57x. We assigned a weighting of 15% for each Enterprise Value multiple as the

above reasons may make BAT seem expensive. We gravitate towards seeing their low LFCF

compared to peers as a temporary problem that may correct in the future with our forecast of top

and bottom-line growth leading to improved earnings and in turn, LFCF.

4 Levered Free Cash Flow = Cash Flow from Operations – Capital Expenditures – Debt and Interest Repayments. 5 LFCF Yield = LFCF/Market Capitalization 6 We calculated Net Debt using the following formula: Total Borrowings (Short and Long-term) + Lease Liabilities + Non- controlling Interest – Cash and Cash Equivalents – Net Derivatives – Investments Held at Fair Value


Price to Earnings Approach (P/E Multiple)

BAT’s P/E ratio implies that they are undervalued as they have a lower multiple (10.76x) compared

to the median (13.23x), which makes BAT trade at a 22.9% discount to the median of the

companies that we used for a yardstick ratio. Despite the huge difference in the size of PMI’s and

BAT’s capitalization, their earnings do not differ by a lot even if BAT is more leveraged and has

more interest payments to make than PMI. This signifies that PMI is trading at a higher price than

BAT but is returning lower earnings (PMI’s P/E: 17.22x). They have similar growth prospects, but

PMI is 60% more expensive than BAT. We gave this multiple an assigned weighting of 35% as

we believe it reflects the current market, and that BAT looks cheap from their favourable growth

prospects.

Price to Book Value Approach (P/B Multiple)

BAT has a P/B ratio of 0.95x, which is slightly lower than the median multiple of 1.27x. This

implies that they are undervalued. The usage of median helped reduce the distortion that the

average P/B multiple would have because of the outlier in Altria’s high number. BAT has a

massive amount of intangible assets, valued at GBP118.7 billion in their 2019 balance sheet. This

represents 84.2% of their total assets and includes trademarks and goodwill of their brands. The

ballooning of their value in assets has therefore, increased their book value (which also lowered

their debt to equity ratio and may give off the impression that BAT does not have significant levels

of debt). We gave this multiple a weighting of 35%.

Growth Opportunities & Market Catalysts

New R&D under BAT

British American Tobacco’s Research and Development focuses solely towards making reduced-

risk products. Their focal items of concern include inhalation science, heating technology,

integrated electronics, new materials, battery efficiencies, fluid dynamics, biotechnology,


manufacturing techniques and aesthetic designs. Their Potentially Reduced-Risk Products is

comprised of an array of technologies. Today, they have leading products in vapour, tobacco

heating products, modern oral products and traditional oral category.

BAT has set their medium-term target for revenue from their new category products, including e-

cigarettes and tobacco heating devices, to grow five-fold to an approximate of GBP5,411 million

by 2023/2024. Their growth strategies focus on investing in a strong range of international brands

that play a key role in many market’s portfolios. Their aim at increasing emphasis on alternative

products like e-cigarettes, medical nicotine products and tobacco heating products is derived from

the perspective of a long-term growth opportunity that seeks to meet consumers’ changing

demands of less risky alternatives. Their innovations in 2014 including the Vype e-Stick and Vype

pen were examples of less risky alternatives.

Potentially Reduced-Risk Products (PRRPs) is a prime component of BAT’s strategic portfolio. It

comprises of vapour products, tobacco heating products, modern oral products and tobacco heating

products. From their acquisition of RAI, their vapour volume was up by 100% year-on-year. Vype

and the group’s other vaping brands grew up to 34% due to market-leading performances in the

UK and France. A lot of its growth prospects were derived from the performance of Vype ePen 3

in markets such as Canada and UK. Majority of THP’s growth is driven from its performance in

Japan, specifically after the release of its product Glo. BAT’s THP volume growth have increased

from 180% in 2017 to 217% in 2018. Their modern oral product, EPOK, has experienced growth

in 2018, increasing revenue growth from 127% in 2017 to 140% in 2018. Lyft, the group’s

tobacco-free product, launched in Sweden, has also achieved a 4.5% total market share.

BAT Malaysia is an auxiliary of British American Tobacco Plc (BTI), and the organization has a

54.4% Malaysian legal cigarette market share in Q4 2019. Due to its dominant market share in the

country, all the factors affecting BAT Malaysia are considered equally important whilst

considering BAT’s overall situation. The growing threat from illegal cigarettes and its impact on

legal cigarettes has actively led the company to approach within tobacco heating products (THP)

and vaping. The recent product that BAT Malaysia launched last year was the Neo Sticks which

returned positive results. THP and vaping products account for about 1% and 9% of the total (both


legal and illegal) cigarette market in Malaysia. This also concludes that in the tobacco industry,

alternatives like the above have a highly considerable demand. Vaping, according to past results

is considered the future revenue driver for the company if it becomes legalized in this country.

Reynolds American, the North Carolina cigarette mammoth behind the Camel, Newport and Pall

Mall brands, is contaminating quickly developing tobacco plants with a hereditarily changed

infection to check whether they can create antibodies for a potential immunization. Utilizing

tobacco plants for medication is an old thought with new life in the coronavirus episode.

Researchers state tobacco has a strange advantage since it's a solid plant that can develop quick,

preferably helping antibody producers scale up rapidly. This epidemic can therefore turn out to be

in favour of the tobacco industry.

M&A Activity Historical Analysis

M&A Trends in the Tobacco Industry

United Kingdom-based Imperial Brands PLC has been considered a smaller player compared to Philip

Morris and British American Tobacco PLC, and therefore may be a potential acquisition target.

Meanwhile, there are several companies in Asia that could drive future M&A activities, including Japan

Tobacco Inc. and China National Tobacco Corp., and it is likely that traditional tobacco companies will

consider areas like cannabis, electronic cigarettes and nicotine alternatives in future deal-making. Among

a number of suitors, Japan Tobacco would be very interested in buying Imperial brand’s fine cut business

because Japan Tobacco has been putting a massive focus on fine cut in Europe in recent years. In 2018,

Japan Tobacco has acquired Donskoy Tabak, the fourth largest tobacco company in Russia at the time,

for 90 billion Russian rubles. In the same year, Japan Tobacco has acquired the tobacco business of Akij

Group, which was then the second largest tobacco company in Bangladesh, for around 124.3 million taka.

In 2017, Japan Tobacco has acquired the assets related to the tobacco business of Mighty Corp. in the

Philippines for 46.8 billion Philippine pesos. In 2016, Japan Tobacco has completed the acquisition of

Natural American Spirit's business outside the U.S. for $5 billion.

In 2017, subsidiaries of Imperial Brands and China National Tobacco established a joint venture to sell

two Imperial brands inside China — West and Davidoff — and two of China National’s brands — Jade

and Horizon — in markets outside China.



Another sign of China National Tobacco's potential interest in international markets was its initial public

offering in June by its subsidiary, China Tobacco International (HK) Co. Ltd. in Hong Kong, said Patricia

Kovacevic, an attorney and regulatory consultant whose coverage include nicotine. Future M&A activities

in the West are likely to revolve around newer product categories as Big Tobacco and start-ups focus more

and more on nicotine alternatives to traditional cigarettes. Altria paid GBP10,431 million for a 35% stake

in Juul Labs Inc., and Philip Morris has invested heavily in its heat-not-burn device IQOS, which Altria

has the rights to sell in the U.S.

M&A Trends for British American Tobacco

British American Tobacco acquired Reynolds American Inc. (RAI) in 2017. This move was

additionally expected to accelerate the advancement of e-cigarettes and vapes. Today, it has

transformed RAI into a world leading vapor company and has allowed it to significantly increase

the size of oral tobacco and nicotine product ranges.

The arrangement was supported by about all investors who casted a ballot at an extraordinary

gathering at the Hilton London Bankside in London (78.2% of speculators casted a ballot). At

Reynolds’ central command in Winston-Salem, North Carolina, in the meantime, by far most

(82%) of Reynolds shares has been endorsing the arrangement.


Reynolds creates a portion of the top-rated cigarette marks in the country, including progressively

famous menthol cigarettes under the Newport brand, such as Camel. The organization was

established as a biting tobacco organization in 1875 in Winston-Salem by Richard Joshua

Reynolds

Today, although smoking hasn't held the marvelousness it had during the 1960s, tobacco

organizations have stayed beneficial. To some degree, organizations have had the option to move

deals of cigarettes to less instructed and more unfortunate purchasers. They have additionally

endured claims and guidelines of the 1990s.

As about the Phillip-Altria deal that did not go through, BAT has somewhat benefited from the

same. The proposed mix would re-join two organizations that split over 11 years back and bring

about a behemoth that would outrank BAT as the world's biggest trade on an open market cigarette

creator. Also, it would put two of the best smoking other options, Juul and IQOS, together under

a similar rooftop.

Year Activity 1999 Global Merger with Rothmans International. 2008 Acquires assets of Tekel, Turkish state tobacco company.

2011 Acquires Protabaco in Colombia for US$452 million and establishes Nicoventures Limited. 2013 Launched first e-cigarette with CTBAT International Limited. 2014 Announces investment of US$4.7 billion as a part of Reynold American Inc’s acquisition of Lorillard. (42% stake in Reynolds American). 2015 Acquires TDR, Croatia & Remaining shares in Souza Cruz. Also Acquires CHIC group. 2016 Products Launched in the market- Glo, THP, in Japan. 2017 BAT Completes Acquisition of Reynolds American Inc.



Corporate Policy and ESG

Environmental Laws’ Impact on Businesses

The most common regulation on tobacco business worldwide is the “Framework Convention on

Tobacco Control” by WHO. In article 18 of this treat, awareness on occupational and

environmental damage brought by tobacco production is raised. Other international environment

treaties which focus on a specific issue also have an indirect effect on tobacco manufacturing. For

example, the United Nations Framework Convention on Climate Change (UNFCCC) targeting gas

emissions, Stockholm Convention on Persistent Organic Pollutants (POPS) limiting the usage of

hazardous substances and Convention to Combat Desertification in Countries Experiencing

Drought and Desertification focusing on land degradation.

Tobacco is one of the most chemically intensive crops, as it requires high usage of chemical

fertilizers and pesticides. Different countries have their respective regulations regarding the use of

pesticides. Methyl Bromide was phased out by the Montreal Protocol in 2015 in 20 states. EU

member states have banned Aldicarb, 1-3 Dichloropropene, Imidacloprid, Chloropicrin and

Carbaryl while the US have banned Chlorpyrifos.

Company Corporate Policy on the Environment

BAT publishes a sustainability report annually and has listed out their performance change from

2017 to 2018 on different indicators in their report released in March 2019. The data is extracted

below.

BAT also performs life cycle assessments to find out which procedure has severe environmental

impact and make sure all manufacture and distribution of their product were conducted with ISO

14040/14044 standards. In 2018, BAT had set new carbon emissions targets for 2030 and had

implemented some policies to achieve their objectives.

For Carbon Emission, BAT has installed on-site solar panels and is going to continue in

purchasing renewable energy. The Santa Fe Factory in the US operates 100% renewable energy.


It aims for a 30% reduction in Scope 1 and 2 emissions as well as having 30% of the total energy

used coming from renewable sources in 2030.

For Water Consumption, BAT implements optimization of resources in production by eliminating

leakages and uses the Integrated Work System. It also increases the recycle rate of water to achieve

the goal of 15% of total water to be recycled and a 35% reduction in water withdrawn.

Environmental Statistics 2017

2018

Change

CO2 Emission 864 841 -23

Renewable Energy 9.10% 9.30% 0.20%

Water Withdrawn 5195 4768 -427

Water Recycled 8.70% 8.80% 0.10%

Waste Generated 160 155 -5

Waste to Landfill 16.20% 14.70% -1.50%

Waste Recycle 89.60% 90.20% 0.60%


Lastly, in terms of waste, BAT compresses waste for recycling and performs waste reduction

activities in production plants in Africa. Its target is to reduce 15% waste generated and 40% on

waste to landfill.

ESG Score Breakdown

ESG (Environmental, Social, Governance) Score is set up to help investors understand ESG risk

and opportunities. Each company is evaluated on the critical issues of their specific industries.

Ethical factors have started to become investor’s consideration alongside financial analysis.

Morgan Stanley Capital International (MSCI) has identified that companies with higher ESG

ratings are associated with “higher profitability, lower tail risk and systematic risk”.



The latest ESG rating of British American Tobacco by MSCI was downgraded to BBB in

November 2019. The rating is based on 11 companies included in MSCI ACWI Tobacco Index.

While BAT has not lagged in any main issues in the tobacco industry, its corporate governance,

product safety & quality, water stress and supply chain labour standards are only of average among

peers. MSCI ranks BAT as the leader in chemical security which shows their products lack the

presence of concerned chemicals in their products. Overall, BAT is ranked average among 11

listed companies in the tobacco industry. Other international conglomerates have a similar ranking

- Philip Morris and Altria are both ranked BB while Imperial Brands is ranked A.

BAT’s rating rose from BBB in 2016 to A in 2017. The reason behind this was the implementation

of a new operation standard on child labour prevention and the launch of the new compliance

program “Delivery with Integrity”. The company put its focus on sustainable agriculture and

farmer livelihood in 2017. The above policies improved the “Supply Chain Labour Standards”

rating. However, the rating dropped from an A in November 2018 back to BBB in 2019. We

believe it was due to the deaths in the US related to vaping last year, and the government’s decision

to ban non-tobacco vaping products. This incident has drawn people’s attention to the hazard of

PPRPs. Since BAT develops vaping products and other PPRPs as a new category of business, the

concern raised in “Product Safety & Quality” ultimately leads to an overall downgrade.


Company Ownership Structure

Institutional ownership accounts for

52.6% of BAT’s shares, with Capital

Research Global Investors as the

largest shareholder with a 14.96%

stake. Within the top 10 institutional

investors, there hasn’t been any

significant selling or buying of BAT’s


shares, none of them has higher than 1% change in shares held. The insiders’ position is

insignificant, and there are also no hedge funds. We believe that the shareholder base of BAT is

stable and has minimal effect on the company’s policy.

BAT’s Expansion Scheme

BAT’s purchase of Property, Plant and Equipment (PP&E) in 2018 is GBP758 million which is

33million less than 2017 and GBP147 million more than 2016. The main reason behind the

increase is the investment in BAT’s global operational infrastructure which includes their

manufacturing network, trade marketing software and IT system. The group also expects an

expansion of PRRP’s production soon by raising its investments in joint ventures. Currently, BAT

uses third-party manufacturers to produce the components for PRRPs including vapour products.

BAT increased its PP&E expenditure in countries outside the UK by GBP286 million including

the 2 new cigarette factories in 2 new countries (Malaysia and Zambia).

Investment Risks

British American Tobacco (BATS) is relatively undervalued, given that it has dependable

diversified brands and strong earnings per share growth than most competitors. Although BATS

has a decent hedging instrument on foreign currency and interest rate, the company is still highly

exposed to the FX depreciation in the emerging market.


COVID-19 Disruptions and Macroeconomic Risks

At this point, COVID-19 has become a global health emergency and an unprecedented situation

that disrupts supply chain and market stability around the world. BATS also bears a high

competitive risk as competition from other tobacco industries will remain steady ahead.

Speculation of Altria and Philip Morris merger in the future could drastically reduce British

American Tobacco market share. Furthermore, the recent regulatory overhang could pose a severe

threat to British American Tobacco as the company is highly concentrated in the emerging

markets. The regulation risk includes scrutiny by the US Food and Drug Administration (FDA)

and Health Canada on unauthorized pod flavors and nicotine oral-based products.

Until there is any resemblance of flattening the virus spread, there will be no guarantees on the

short and long term impact on the economy. Based on the Economist Intelligence Unit, COVID-

19 is likely to send almost all G20 countries into a recession. Likewise, commodity risk is

emerging, the Russia and Saudi Arabia oil war escalates, and prices have gone too much to endure

with new lows in the real price of oil.

Systematic Risks Geographically, BATS main operating business comes from the emerging market, which consists

of around 50% of its total revenue. With that being said, political unrest, epidemics, earthquakes,

and other uncontrollable events could significantly impact its financial stability. They are also

exposed to brand risk, such as management scandals and insider trading, that could substantially

reduce their brand image and lose consumer confidence.

On the other side, the market is trading based on liquidity and not off of economic fundamentals

for the past 12 years. With the bank stepping away, we might be in the grip of a global liquidity

crisis.


COVID-19 Potential Vaccine

The race to find the COVID-19 vaccine is very important for the global economy's survival. Major

players in the Tobacco industry are developing COVID-19 vaccines by using tobacco plants as a

source. Yet, the involvement of tobacco companies in the war against COVID-19 may be

considered by some officials as a paradox.

The assumptions are valid on the date of publishing. However, there are evolving risk and

uncertainties from the market, for example, the industry conditions, competition, future regulation

changes, firm instability, and legal risks, which cannot be addressed extensively.


Appendix

Appendix 1. Income Statement



Appendix 2. Balance Sheet



Appendix 3. Statement of Cash Flows



Appendix 4. Comparable Company Analysis Model


Documents

Equity Research British American Tobacco