British American Tobacco p.l.c. (BATS) Earnings Call Transcript & Summary

Hi. Good afternoon, everyone. Thank you for being here. I'm Gaurav Jain, Barclays Head of Global Tobacco and Cannabis and EU small and mid-cap. With me here is Kingsley Wheaton, BAT's Chief Strategy and Growth Officer. To start with the presentation from Kingsley before moving into Q&A. Over to you, King.

Thanks for the warm welcome, and good afternoon, everyone. It's a real privilege and a pleasure for me to be here. As a way of introduction, I've worked for BAT for 27 years, all over the globe. I've on the management team for [ targeting ] us in different roles. It's a real honor for me to be here to talk about this subject in particular. And that is how the organization created a purpose for and profitable pathway to our vision, which is a better tomorrow. It's all our new category of journey. It's a slightly different hopefully impression take on how that journey is unfolding and will unfold. And I'll take you through some of the key -- salient points of what we're up to in terms of creating value for the long-term and sustainable value of that. So I'm just going to quickly flick through 2 disclaimer slides there they are that will go up onto our website. And today's teams are the following. I suppose if I was to make some key messages for today. A multi-category portfolio, we believe, is essential. I'm going to have a look at that, and I'm going to try and explain why we believe that is the case. But tobacco harm reduction as a public health choice but also strategic care value is a journey and not an event. It's something that's building over time, and I want to have a look at that. And also the global act at the end of that with new categories to us our value-enhancing or value-accretive, and I'm also going to take a look at that. So those are the 3 big themes of today. Just to recap my part of BAT is to build a better tomorrow. That is simply about transitioning our portfolio from combustible cigarettes, the products that largely caused the harm for our portfolio to opening a greater choice of enjoyable and less risky products for our consumers. And indeed, that journey is well developed. If you went back not that many years ago, about 0% -- precisely 0% of our portfolio would have been in noncombustible category products that all have been in combustible tobacco. At the half year this year, we reported that nearly 17%, 16.6% on 6 of our business now today is in noncombustible products, collecting a much more sustainable portfolio into the future. And in doing that, our ambition is to create value for multiple stakeholders. For our consumers who will have greater choices to enjoy tobacco and nicotine without the risks that were in the harm that combustion causes, for our investors, whether that be our equity investors or our debt investors as well for our employees, there are 55,000 people at BAT, that I think also anchor after to a sustainable value-creating future for BAT. And finally, for society as we seek to reduce the harm that smoking causes around the world. And by doing this, we can create value for those 4 big stakeholder groups and actually many others besides. And the other point I wanted to make is it's still fairly early days. There were about 1.1 billion smokers worldwide. That's per the WHO estimates. And there are 100 million users of new category products worldwide. Probably the first new category product users came on to the scene somewhere around 15 years ago. So in that time, GBP 100 million, you can see there's an awful long way to grow and also long way to go and grow in terms of creating value as we transition more and more smokers into these alternatives if they choose not to quit. Now increasingly, this is becoming a global phenomenon. I suppose you could take what's on this slide in 2 ways of our top 50 markets around the world, 60% of them around 2/3 are open to all of our new category products. That still means, of course, that 40% of them are not. And this is a dynamic picture. This has evolved over time. And I think more and more markets are adapting to the new reality of the categories as that tobacco harm reduction journey is better understood. Nevertheless, around 30% or 1/3 of countries in the world with strict one or more of the new category opportunities. And there are many very key global markets cited here, Brazil, Mexico, Turkey, I can add to that, Australia as well, where they are inaccessible to new category alternatives. So we've got work to do in terms of shaping a progressive environment in which we operate, working with stakeholders, governments, regulators and policymakers to shape that environment where our portfolio will subsequently land and be presented to the consumer. And finally, if you look at that market and footprint, I think it's very fair to say that markets and consumers are simply not homogenous. There are fundamental drivers. This comes from our key consumer insight work, 6 key drivers of why consumers adopt the category products, if they choose not to smoke and make that switch, switch to better. And then there's a case for occasions and consumptions and moods and moments and consumers are different around the world in that regard. And then regulation and market access, which varies from country to country to country. So if you lay out those 3 dynamics on top of each other, it becomes fairly obvious very quickly that no single solution is capable of meeting all consumer preferences. And just like you would find in perhaps the alcoholic beverages industry where beer and wine and spirits and mixes and so on, satisfy the consumer needs that are derived from alcohol. So through that is true in our industry in terms of requiring a plethora of category solutions to meet all the consumer needs, market needs and consumption needs. So we're investing less heavily now in building that multi-category future in order that we can deliver sustainable, high-quality growth well into the future for BAT. BAT is 126 years old this year. It's a tremendous story of resilience of success, the value creation. And I see no real reason why it wouldn't get to the grand old age of 252 years old being thriving and flourishing, probably with its selling cigarettes being a dim and distant memory. So let's have a look at some of the belief. Some of you may know a lot about this area. Some of you may know a little bit, some of you may know enough to challenge some of our thinking, and you may have heard some of these things before. Let me take you through these timber leaps. First of all, I believe that there is a one-size-fits-all solution to tobacco harm reduction. Secondly, the tobacco heating products that heated tobacco products attract the most consumers. Thirdly, the tobacco heating is much better, is much more successful in switching consumers out of smoking, which after all is our ultimate aim for vaping. You may also have heard that Modern Oral is just a slightly quirky Scandinavian solution and has no global footprint in the future. Come on to another way that nicotine is a substantial cause of disease. You might find it strange, and I put that up there. Per recent data in the U.S., 80% of health practitioners in the U.S., state nicotine is a cause of illness, 50% of British general practitioners state nicotine is the problem. So there may be an understanding of that within the industry, but there's certainly not an understanding of society at large. Another thing that's often on as that new categories are simply conspirator plot by us to create value, to have people move back into smoking, what's called the gateway, and I want to talk about that. The poly uses at this stage of poly usage on the journey as people switch out smoking. Consumers tend to smoke just as much, but somehow new categories sort of equally used and adopted by different age cohorts. I think we have far more precision in our insights and therefore, far more able to be predictive about the industry's future. And as we kind of got through those 8, then finally, often when I'm sitting down, people say, yes, yes, it's all great, but new categories are less profitable, aren't they? And actually here in volumetric decline in combustibles and therefore, industry decline must just be eroding. So I'll address at least 9 and 10 at the end. So looking at the first one, one-size-fits-all. I think it was a reasonable job done just earlier on one of the pages to explain why when consumers are not homogenous in a multi-category solution is needed. That might be conceptual, that might be a theory, here's some data and some facts just have a look at the data and the facts. If you correlate the penetration of tobacco heating usage in different markets around the world and vapor usage, they tend to correlate inversely to the weighted average time-off of the marketplace. Let me put that into layman's language. As cigarette deliveries get less and less strong as you go around the world, tobacco heating stands a greater chance of working. A prime example of that would be Japan. Sales weighted average tar is a measure of declarations on the product. And as you head into the higher tier markets, notably Canada and the United States, you have a much stronger penetration of vapor. You might even argue that U.S.A. and Japan are outliers because of the presence largely of only one predominant category. Of course, there are many more data points here. And for the analysts amongst you, the [ all square ] is pretty strong on THP at 0.6 and is a 0.4 [ all squared ] on the vapor numbers. So evidence of a correlation there is a relationship between weighted average tar and preferred product usage. Believe 2 is that THP is a witting format and attracting most of the consumers. This is consumer data over 5 years you'll see of those 100 million smokers I mentioned around the world, 62 million of them or 2/3 of them are vapor users. Some of you may also have [indiscernible] off in the past has that not been inspired more recently by modern disposables. Well, that's largely at [ 22 ], the dip you see in 2020 is more likely a little COVID disadvantage and a change of trend. So you see the trend as being fairly consistent. Only 17% of vapor users using modern oral are using the [indiscernible] basis 70% are using a [ mono-repertoire ] basis with rechargeable vaping products. You also don't count to consumers twice. So net new category consumers around the world are in vapor. And then if we have it switching. So they're all making a but vapors not as effective in a tobacco harm-reduction journey. Well, here's data from what, 5 big markets beyond Japan. This data is often presented through the eyes of Japan, which obviously is a low sales rate to average tar market. Now this chart across Canada and across Germany and across the United Kingdom and Italy and Poland, you see that consistently vapor acts to switch consumers out of cigarettes as well or maybe slightly better than tobacco heated products. So vaping also capable of switching consumers. I believe 4, [ that more ] is this quirky Scandinavian phenomenon. But if you have a look at the facts, the data, actually, even in 2023, we estimate that 75% of modern oral white nicotine pouch revenue around the world will come from non-Scandinavian markets, with the rest of the world now approximating to roughly what Scandinavia is worth with about half the market in the United States. We actually think and are very excited about Modern Oral going forward. Yes, it's a unique format. It has certain consumer disadvantages. It has many, many consumer advantages. The user journey is harder to get consumers through to adoption. But at the bottom end of the consumer funnel, when we get into regular usage royalty, service usage and advocacy, modern oral performs better than any of the other categories. So if we start to build bridgeheads, we're starting to build bridgeheads with modern oral now in what I would argue some surprising places in Pakistan. In Kenya, actually, the business in Poland is going very, very well despite tobacco heating and vapor been very, very prevalent. So we're starting to see more and more success in modern oral. And I think that will continue and who knows possibly even as [indiscernible] nicotine journey as we think about actives beyond nicotine alone. So if these are true, if the factual contextualization of the industry of 1, 2, 3 and 4 are correct, then it would imply that a multi-category portfolio is essential to deliver both our purpose and industry transition. Let me take these next 4 head on as a save largely about tobacco harm reduction. Well, here we have Scott Gottlieb saying, it's not the nicotine that's the problem. The Royal College of Physicians that says nicotine is not the problem. And again, I think for those that are initiated in the industry, that's a well-understood fact clearly less well understood. Another reason why we need to work much harder as an organization and join forces externally with regulators and policymakers to try and create a catalyst for a more progressive environment that tobacco harm reduction is better understood and the role of nicotine is better understood. Number six, the belief that somehow new categories of gateway to smoking, young adults enter into vaping perhaps or tobacco heating and somehow end up becoming cigarette smokers as the result. And here, you can see data across multiple markets that basically shows there is no evidence of a gateway effect out of products back into smoking combustible products from new categories. These rates are substantially lower than the entrance rates in these markets into smoking alone. So I think what's often we're accused of that we're creating this gateway, but the data release doesn't seem to be true and there was no suggestion drivers you see in the years go on, that this is increasing. Let me -- 6 jump to [ 8 ] anyway, maybe it's a numbering thing. Also, the new categories will be used equally across different age cohorts. In fact, what you see is something quite different. The first column is adult users under 30, the next column is 30 to 44-year-old or the row and the next one is adult users over 45. And you'll see that new categories, penetration, whether that be [ solace ] usage or dual usage varies inversely with the age cohorts of consumers. And you might say, well, so what does that mean? What it means is if you roll this forward in terms of cohort analysis, if you're predictive about the future, you're going to have generations of consumers who are increasingly persuaded by new category products and are going to smoke less and less and less. And as we come on to the value side of things, of course, that matters to demonstrate that the usage of these products is valuable and therefore sustainable. I believe 7 or longer anyway, there we go, 8 to 7. The belief that somehow poly usage as we think about this journey of tobacco harm reduction tends us smoke just as much. I think sometimes it's called the off-ramp, the off-ramp from smoking to some alternatives. This is not a binary choice between smoking and solace usage. Of course, we all wish that we would get consumers to solace usage of new category products as quick as we can, if they choose not to smoke. However, in that journey, there will be poly usage. And here, you see package of markets, I think there's 12 markets where if consumers are using cigarettes and THP, they smoke 8% less than they otherwise smoking on a daily basis. If they're using modern oral 17% less. And if they use it in partnership with vapor 19% less. So we do see a reduction in amount of cigarettes being consumed on a worldwide basis as a result of poly usage, which was an inevitable stage with the transition of the company and of the industry. So I think thinking about those 4 points, tobacco harm-reduction is a bonafide corporate for us and also societal goal in terms of coming up with public health policy, which deals with the harm that smoking causes. And finally, on to the commercial side of things. Of course, they are less profitable. I hear a lot and industry value is simply being eroded as volumes decline. To explain this chart, new categories are already positive at a gross margin level in almost all categories. What you have here on the verticals is tobacco 18, modern oral, vapor rechargeable, vapor disposables on the left-hand side the countries. And it depicts the relative amount of margin versus somebody who smokes on an annualized basis. So in France, for example, we will take the average. The average daily consumption, the ADC on like Lucky Strike, can't say what's that worth in terms of gross profit for us. And we would set that aside somebody who's using vapor on our same ADC rates. And what you see is almost everywhere in the world with a couple of exceptions that are already new categories on an absolute margin prior consumer user per year basis is as, if not more profitable than a cigarette consumer. And this is dynamic. If I put this chart up, when I put a slide running next-generation products in 2015, I suspect they would have all been yellow. So we're seeing a dynamic forces here. So I think even the yellows over time as we build scale, figure out better innovations with our innovation obsession, build better consumer satisfaction is going to deliver a better and better and a stronger margin profile. And here that the demise of our industry is somehow forecast based on volumetric decline, you'll see that even though in the top 10 cigarette volumes have been falling by 6% over the last 2 years on a CAGR basis, the industry has been growing value by 3.4%. That's a function of, a, the pricing that we're able to deliver despite our volumetric decline on the combustible side and the fact that all the value accretion is coming through new category products. So total nicotine revenue is growing year-on-year with new categories driving that value accretion. So those are the 10 facts that I've taken you through. I just want to sort of summarize and get on to a Q&A in a short moment. So the multi-category portfolio is essential. Tobacco harm-reduction for us is a journey and new category products are value-accretive. I just want to do one more quick one. After we hear that Japan is the sort of bellwether transformation of the industry. Well, actually, a little closer into our home, a transition in the market has been happening for a long time, and that is Sweden. Sweden has successfully delivered a multi-decade tobacco harm reduction policy. This is the FMC incident, Sweden will be probably become the first country in the world that will hit smoke-free status at below 5%, all founded in an oral tobacco history that goes back many, many decades and also a country that has the lowest smoke lung cancer rates in the world. Don't just take my word for it. Let's have a look at this quick video on what Sweden has achieved in terms of tobacco harm-reduction. [Presentation]

So a remarkable story in Sweden, which brings together many of today's teams. I think some of the facts that we're trying to outline how we create value and how we create high-quality, sustainable growth. Very quickly, we're already 12 of our key markets around the world, we see double-digit, in some cases, high double-digit revenue contribution of new categories to our business, obviously, with Sweden being the highest nearly [ 3 ] quarters. Having 23 investment markets around the world, we have more than 30% of our revenues today already in new category products that's high as 70% in the 3 quarters in other markets. And as I said at the beginning, we've only just begun 100 million users of these products, GBP 1.1 billion is focused. And that's how we're going to create a notable and profitable pathway to our better tomorrow. Thank you very much.

Thank you so much, Kingsley. Very interesting presentation than what I was expecting. So thank you for that -- so we are very conscious of time. We have 9 minutes. We will also have a breakout after this. So I will ask a few questions which are on top of investors' minds. Number one is that there have been management changes this year. We had a certain CEO departure and a new exec board has come in. We still have a CFO announcement to be made. So could you just help us understand what are we in the transition? And when can we expect a new CFO announce?

Yes. Of course, and I'll try and be quick mindful of time. Of course, it all starts with a strategy. We have the right strategy. And I think there's a very strong feeling that we do. And actually, in many ways, what I outlined there was the strategy. What we have to be able to do is execute that strategy better. It is fair to say, and I think the examples are well known. There's been some areas where we could have executed better, looking to stabilize and create a more sustainable United States business. We need to get better in terms of tobacco harm -- tobacco heated products pipeline. And we need to focus on few enough things and doing those better. I think the Board looked at all of that in terms of what was needed, concluded that today, it was exactly the right person to take us forward and I'm very honored to be representing here today. I've worked with today for a very long time for over 2 decades. And I think he is the right person to bring that [indiscernible] and that calmness into the business in order that allows us to execute strategy. From a CFO point of view, that was your other question. Obviously, there was an extensive excel search ongoing at the moment. Looking at [ putamen ] CFOs in probably in a plc environment with a track record of transformation of some disruption coming in with a fresh pair of eyes. That's not to say that we don't have a great internal bench of possible CFO candidates as well. And we'll make an announcement to the market as soon as that process has been completed.

Sure. Now you highlighted the challenges that have happened in the U.S. business. Now as we look ahead, over the next, let's say, 3 years, U.S. cigarette industry volumes down 8.5% on what was a easy comp in which you lost share. Then U.S. E-cigarette clearly, you did pretty well this year and increasing the profitability but now we are seeing disposables if it's come in, [indiscernible] enjoy. So E-cigarettes probably volumes go down here and you probably can't price up now. And then we will have next year, PMI enter the market with high cost, but I like that slide, there was a correlation between tar and penetration rates. So is it the way we are thinking about that U.S. businesses that now EBIT will be flat while historically it used to grow high single digits. So how should we think about your overall U.S. business?

Yes, I think the most important thing is that we create a business that's capable of delivering sustainable value accretion over the medium to long-term. And that means that there's a few things that we've got to correct or fix. I mean some of that is now under a [ David Waterfield ] watch who's gone in the CEO of the United States, somebody who I know tremendously well, previously led our Western European business. And if you saw the number of Western European markets that we were featured in terms of the transition, I would tell you that he's done a tremendous job there. So I think stabilizing the business, we've had a good first half, lapping from a share point of view, some tougher comps in the first half of '22. We've seen some early signs of premium stabilization by definition, if you see premium stabilization, that would be underpinned by some of the Reynolds portfolio. And Newport and NAS, especially have performed well. I think vapor is going tremendously. By the way, we grew 20% from a revenue basis in the first half. And I think it's really -- again, it's about an execution challenge in the U.S. in terms of using our state architypes model in terms of using RGM, getting more tailored and better in terms of precise in terms of cross elasticity of demand between our products and the other ones that are available to consumers. And I think as the market, we've been through a particularly bumpy period in terms of the market in '22, '23, I think our medium, long-term view is that the market will settle down to decline rates that become more secular and those that we're more used to. And I think we're going to be able to deliver combustible value from the U.S., so I think they're going to be able to deliver transformation value, and I think we deliver from new categories. So medium to long-term, I feel good about it. But I think we all recognize the next 2 or 3 years, there's a lot of work to be done, and it will take some time to get the U.S.A. sailing again in clear water.

Okay, sure. And still sticking with the U.S., use [ Alto PMTA ], it's almost, I think, 3 years now that you filed for it, we're still awaiting it. What is your expectation? And if you don't get the PMTA for tobacco, then what happens to your e-cigarette business?

We're probably across the second bridge when we come to it, Gaurav, if you don't mind. But we're hopeful for a decision by the end of the year. We think -- we feel in a good position. The same fundamental science approach, submission documentation that was used for [indiscernible] and Vibe and one other, I can't remember off the top of my head, 3 of them that have been approved is the onto underpin the out. The FDA come out with quarterly update slots they're talking about having created, I think, a 6 and 6 applications by the end of the year. So we're very, very hopeful that there will be from the FDA in that -- within that timeframe.

Sure. Now one key question around BATs of share repurchases. So you had a bigger-than-expected share repurchase announcement in FY '21. GBP 2 billion. This year, it went below what investors were expecting you skip the share repurchase. And now as we approach our annual results in FY '24, that question is going to heat up a lot. And your leverage is now closer to 2.5x, which is our stated range, 2x to 3x. So how should investors be thinking about share repurchase by FY '24?

I'm really mindful of answering that question is the strategy and growth guy with the interim Finance Director here, but I'll give it a go. Of course, the other thing that's fair to say in that period from '22 to '23. I mean the world has changed a bit as well. And there's been a pretty choppy external environment marked by rising inflation in Ukraine Russia war rising interest rates and the ensuing implication on net finance costs. And I think it is worth saying all of that because it does mean that in terms of capital allocation, we've decided to prioritize the paying down of debt alongside the dividend. We're committed to a 65% dividend payout ratio. We've had an increased dividend, I think, every year for the last quarter century, 25 years. Some of that -- I know a lot of our investors do care a lot about. And in this environment, we'd just like to focus on paying down debt until we bring debt back into closer -- much closer to the middle of the corridor of our 2x to 3x EBITDA. So that's what we're doing. That's the choice of the Board supported by the management team, and we'll keep reviewing that on an ongoing basis as capital allocation is inevitably somewhat dynamic.

Sure. In terms of a couple of regulatory topics. One is the EU flavor ban on heated tobacco, which will come up on 25th of October. And 70% of your portfolio is in flavors, I'm correct? So is that a big issue? How are you expecting to handle it, especially experience in California was not as good as I think we would have expected. So how should we think about that?

Yes. I mean we are very disappointed with the way these move forward in terms of flavor on tobacco heating products are. Our position is it using or it's coopting a part of [indiscernible], which wasn't designed for tobacco heating products. But nevertheless, we are where we are. It will take some time for the 23rd October for markets to fully transposed that. So we suspect that from the 23rd of October, you probably have a 6-, 9-, 12-month bleed in period as those products will be taken out on a market-by-market basis. And we think it's just wrong for tobacco harm reduction because flavors, adult directed flavor, responsibly marketed and a way of giving consumer satisfaction. Nevertheless, although you're right that we had a predominance and somewhere around on our products are flavor based. If you look at the absolute volume that's available and our competitor has a much bigger amount of quantum of volume, so we think that there will be an opportunity for quite a large amount of consumer reevaluation, we appraisal, therefore, consumer switching. And we're hopeful with the plans that we have which we're obviously going to the market soon to deal with that flavor situation that we could do quite well out of that. So we're looking forward to it. We don't think it's going to be hugely material either way to how BAT performs.

Sure. We are out of time. So we'll go to the breakout room, and we will continue our Q&A there. Thank you so much Kingsley. Thank you in there.

Thank you, Gaurav.