- The Japanese market, the pilot market to heated tobacco products, is critical to study to get a sense of the competitive dynamics for this disruptive product.
- With Altria still waiting for the COVID-19 restrictions to pass before getting started in larger scale rollouts, they relinquish a critical first mover advantage.
- We think Philip Morris could start re-evaluating how to treat its deal with Altria, and that BAT has better optionality for the US markets in heat not burn.
- Altria has its non-combustible portfolio that is doing very well, but given the multiple, there are too many risks on the horizon.
Heat-not-burn is the key theme for tobacco nowadays. The product category has proven to be a source of margin expansion for companies with successful launches, and their dynamics are highly disruptive due to the way it cannibalizes business from traditional products, but also onboards new heat-not-burn smokers from competing traditional products. The big players here are Philip Morris (PM), Altria (NYSE:MO) which sells Philip Morris brands for the US, and BAT (NYSE:BTI).
BAT has been a laggard in the heated tobacco rollout, their glo product not achieving as much success as IQOS. However, due to the COVID-19 pandemic, the Altria IQOS rollout has essentially gone nowhere, with non-combustibles delivering the results for the company in the meantime. A year on from when Altria first reported its COVID-19 quarter, we are beginning to assess the risks that are mounting to Altria on account of this slow launch. Given the recent rally, we think that other Tobacco players present less downside, where increasing optionality of BAT puts it in a relatively attractive position. As such, we are now passing on Altria.
A rally of 30% from our buy-point changes the risk-reward profile a lot for stocks like Tobacco stocks, and as such we should review the position. Altria is now as expensive as PM in terms of PE (Altria~ 20, PM~ 17) as well as with EV/EBITDA in the 10.5-11.5x range, with similar yields (US companies always have a bit higher yields than comps). Here is why we think this valuation situation insufficiently reflects Altria's divergent risk profile.
1) IQOS rollout has not progressed in the US due to COVID-19, and it probably won't for many more months. This presents 2 problems:
First is that BAT glo can consolidate its strategy and go for the win in the US market, where they failed in other markets by being the second mover. There is no guarantee that IQOS has an advantage without moving first which they have everywhere else but the US. The first mover advantage is very substantial as seen for yet another quarter in the Japanese Litmus market, but this could be tossed up in the skirmish for the US market. Below is where a 7 quarter head-start gets you, which Altria will not get in the relevant US market. For longer horizons, check out our last article tracking Japan.
(Source: Japanese Ministry of Finance)
The second problem is that if Altria does not produce results for PMI with IQOS in the US, it could create problems with the licensing agreement since IQOS rollout, forecast over several years, was a key condition (we know this from scant disclosure in Q2 2020).
Our commercialization approach is designed to maximize the organic growth potential of IQOS by focusing first on the densely populated metro areas and then expanding outwards as the user base grows. Our IQOS agreement with PMI has two important milestones. First, PM USA would maintain exclusive license for IQOS upon achieving a five-tenth dollar share of the cigarette category in a single geographic area within a specified time period by April 2022. And second, our distribution agreement has an initial five-year term expiring in April 2024.
The initial term has a performance objective of reaching a five-tenth dollar share of the cigarette category in a certain number of geographic areas, each within a specified time period. Once achieved, PM USA has the option to renew for an additional five-year term. Based on the early results we've seen in Atlanta and Richmond and our robust expansion plans, we believe PM USA will achieve their performance objectives. We're excited to continue building IQOS momentum and executing our expansion plans.
Billy Gifford - Chief Executive Officer Q2 2020 Earnings Call
Even if the agreement doesn't legally collapse, it may cease to be very beneficial to PMI, and they might feel it is economical to move into the US directly before April 2024, the expiration of the first term of the agreement, to make sure that their product sells, even if it means legal repercussions. The licensing agreement was certainly not conceived with COVID in mind, so things have changed and we should consider that in our risk management. Since very few retailers sell IQOS yet, PM could establish relationships directly and deprive Altria of much of this opportunity.
The commercial terms of the licensing agreement are still very confidential, and we know little about them, but a non-compete should not be assumed to be a part of them. Overall, this risk is quite remote, but it should be considered possible as this is how business goes, and it would be devastating should it come to pass. We should not expect PM to buy Altria as a resolution for this situation either, since they would have done it by now if they wanted to. PM should be considered a potential competitive threat to Altria.
2) The second risk is well known to us. The US is a relatively 'woke' market, and is more exposed to cigarette declines than most other markets like Eastern Europe, Southern Europe and parts of SE Asia. It's dangerous to be a business focused on that geography alone with a portfolio of products that are hated by regulators and much of the public.
Overall, Altria is ultimately a much more marginal company than PM and BAT which has international exposure in diverse markets. These factors pose more risk than a multiple almost equal to PM implies.
BAT as an Alternative Tobacco Exposure
As an alternative to Altria, where PM has already had a major run, we think that BAT could make a lot of sense.
1) Firstly, BAT has a higher dividend yield at the moment, and is substantially cheaper. While it has lost out much market share to PM in heat-not-burn, they might win it back over the years as when people decide to upgrade their HTP device, they might shift to glo which is cheaper at the moment. I look at it like an Android/Apple situation, where people will have to upgrade eventually, and it provides a juncture in which BAT can step in and win back some customers.
2) The US market is big. With the delays to Altria, BAT's chance to win there has gone up a lot, and the market is not recognising the increased value of BAT's important US business 'option'.
3) Moreover, the Japanese market has shown that traditional products don't completely go away, with heat not burn growth tapering in Japan. While heat not burn is important, traditional products should not be underestimated. With great brands, BAT's traditional business is being underestimated with respect to Philip Morris, where the narrative is increasingly around IQOS. Indeed, these brands perform very well, and have in fact delivered performance often in line with PM, despite weaker performance in HTP, with 10.5% growth in operating income to PM's 15% on a non-fx adjusted basis.
(Source: BAT FY 2020 Results)
Credit where credit's due, Altria has done an excellent job with their non-combustible portfolio, and the issues with IQOS are really not their fault at all, but ultimately we cannot bring ourselves to buy their business when the US market option is becoming increasingly cheap with a BAT investment hanging at a multiple of around 8.5x EV/EBITDA. With a win in the US market able to propel BAT forward to a growth profile more in-line with PM, we see more favourable risk/reward there, and just don't feel it's necessary to stick with Altria in an extended run.
This article was written by
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