British American Tobacco: Clearing the Air - [Business Breakdowns, EP.162]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. Today, we are covering British American tobacco. My guest for today is Evan Tindall, co -founder and CIO of Byrem Capital. Now, regardless of your views on the actual product of tobacco, the market is one of the oldest in the world. Evan helps us cover how that tobacco market evolved, and we go way back in time, how the product itself has evolved from smoking pipes to cigarettes to what we're seeing today, the nicotine pouch market and all the craze around it.

1:27And we cover how you evaluate a company where the market outlook is so uncertain. My favorite part of this conversation may be getting some background as to the name of British American tobacco. It's always one that has stood out to me. And the dynamics of international versus domestic are truly unique in this market. So a lot to consider here. Please enjoy this breakdown of British American Tobacco. All right, Evan, I'm excited. We are finally breaking down British American Tobacco. It's been a name on our wishlist for quite a while, really since the beginning of business breakdown. So excited to get to it here.

2:06And I think we start at the top. It's a very obvious industry in terms of what tobacco is. But I think understanding who British American tobacco is, is a good place to start. So maybe you could just walk us through what they're actually selling, what BTI is made up of, and anything else you think is really important to just have right off the top. British American tobacco is primarily selling tobacco, surprise, surprise. and they are roughly 50%, 45, 50 % US, a third Europe and the rest Asia and profits are probably a little bit more weighted towards the US. They have about 24 billion pounds of traditional tobacco sales.

2:51That's primarily cigarettes, also some cigars, also some chewing tobacco. And then they have 3 billion of what's called reduced risk or new category products, which are modern oral products, which are just a nicotine pouch that delivers the nicotine directly to your mouth. vaping products, which people in the US are probably familiar with, and then a heated but not burned tobacco product as well, which is technically tobacco, but it's not burning the tobacco in your mouth. It's just heating it up just enough. And so within those 24, 25 billion of traditional tobacco revenue, they have some pretty well -known brands, especially in the US.

3:38Most of the top brands that aren't Marlboro are British American brands. It's Newport, Camel, Kent, Dunhill, Paul Mall, Lucky Strike. Those are some of the main brands. And we'll get into the history. But a bunch of those they acquired via their acquisition of RJ Reynolds. Between 2004 and 2017 is when they slowly consolidated control of RJ Reynolds over time. I know we're going to get into that innovative product category, but just to hear the split of 24 versus 3 is interesting. And I can imagine which one's growing faster at this point. But let's get into that history a bit from my sense of the research.

4:17Looks like this has become a consolidated industry over the years and you have major players. What does BTI look like basically start to finish? And maybe in the context of the industry as well, if you have any general market share numbers or anything you could share around that. So the thing with tobacco is you have to go back a long time. So British American was formed in 1901. I'm going to take us back to thousands of years BC, if you don't mind. Oh, yes. We love history. Yeah. So tobacco was used amongst Native American tribes, both North American and South American tribes, for thousands of years before Columbus got there.

4:58It was used for all sorts of different reasons, as various rituals, as a community building, just to get high. basically everything that you can think of that you might use a product like nicotine for. When Columbus first landed in the New World, he was actually given some dry tobacco leaf when he first got there as kind of like a present. So you can see how kind of important it was in some of those societies. But as far as the company and commercialization history is sort of European focused, that really started, especially in the colonies with John Rolfe, who planted the first tobacco plant in Jamestown in 1612.

5:37And it sort of might be underappreciated how important that was for kind of the development of the colonies because it turned Jamestown from a ragtag group of people who like in one year, only 40 people at Jamestown survived. But then with tobacco, it was turned into an actual like financially sustainable colony. And then basically tobacco was off to the races in the U .S., came side by side, the slave trade as well over the next couple hundred years. Then I'll fast forward to 250 years. The tobacco industry grew, primarily loose leaf tobacco sales. Chewing tobacco and pipe smoking were common.

6:15But then in 1880, a device was created called the Bonsac device, which took the production of cigarettes from a couple hundred per day to 70 ,000 per day. So it basically decreased the cost of producing these things by more than 50%. And the guy that bought the first machines decided, his name was Buck Duke, which just sounds like a guy from the 1800s. Of course, Buck Duke is going to try to create a tobacco monopoly, right? Like it just sounds like what he would do, right? And he did it well. He did it well. He bought these devices. He spent a bunch of money on advertising, which was an innovation back at that time, creating some of the first early brands.

6:56And in 1889, he formed something called the American Tobacco Company, which was essentially a monopoly on tobacco production and sale in the US. You'll notice we're getting kind of close to 1901 or 1902 when VAT was created. And so in 1901, this guy Buck Duke decided he was going to take his business and try to go compete with the British manufacturers in England. And they didn't like that, unsurprisingly. So they kind of circled the wagons and 13 British companies formed what's still known as Imperial Tobacco. and they decided to fight off ATC from the US in every way possible by pressuring UK retailers not to sell their stuff.

7:40They actually came over to the US and tried to start buying stuff in the US just to like mess with them on their home turf. And they spent a year doing that. And then pretty quickly they decided, you know what, instead of fighting each other, let's just agree to have our own monopolies on our own domestic turf and then create a third business, a joint venture that would sell our products overseas. And that was British American Tobacco. So you can kind of understand now where the name comes from. It literally was American Tobacco and Imperial Tobacco, creating a combined company. For a long time, British American Tobacco was, that was their thing.

8:16They were selling Imperial and American Tobacco brands overseas. And it took them a few decades before they started to get back into, they're still not a major player in the British market. But over time, they did enter the US market. And they did that by buying a company called Brown and Williamson. I think that was in the 60s or 70s. But by then, the US had become a more competitive market because in 1911, the Supreme Court ruled that American tobacco was an illegal monopoly and broke it up into three different companies. The lesser discussed, yeah, of the standard oil versus the American tobacco.

8:53It wasn't the first company that this happened to, but it had this playbook for kind of breaking things into its parts. American Tobacco was founded in 1889, and the Sherman Antitrust Act was passed in 1890. So I don't think that was a coincidence. But over the decades, you know, in the US, you had various brands that were introduced. One of the first successful brands was introduced by R .J. Reynolds, would later become owned by British American. And that was Camel in 1913, which was like one of the first national brands. So over time, R .J. Reynolds and then later Philip Morris became like really strong competitors and came to dominate and do really well in the U .S.

9:32market. They began to navigate a sort of increasing regulatory environment because in the 1950s, a bunch of studies came out. And that was also when the Surgeon General first sort of declared that there was this strong correlation with lung cancer that these companies needed to worry about. It was at that time in the 1950s that Marlboro decided to switch from being a women's focused brand to being a men's cowboy brand. And obviously, that is like a case study in itself of sort of marketing prowess. In 1972, Philip Morris became the largest tobacco company in the US. But basically, the 80s and 90s were decades of BAT, but mostly R .J.

10:17Reynolds consolidating the U .S. industry, the non -Philip Morris U .S. industry. You had them merge with American Tobacco in, I think, 1994. You had them merge with Brown and Williamson in 2004. You had them buy Lorillard, which made Newport in 2014. And so increasingly, R .J. Reynolds sort of gobbled up these second and third players. And meanwhile, British American, And based on the deal to merge with Brown and Williamson in 2004, they owned 42 % of that company. So this was largely driven by BAT kind of strategy. You know, they didn't technically control the business. Obviously, if you own 42 % of something, you have a big say in what goes on.

10:58And then finally, in 2017, they pulled the trigger to buy the rest of it. So BAT took on a big chunk of debt to do that. But then they basically became the very strong number two player in the US, number two to Altria, which is... And there's just so many company names and mergers and acquisitions. It's just so complicated. But Altria is the company that took over the Marlboro brand because after the US really started cracking down from a regulatory standpoint, Philip Morris split into Philip Morris International and Altria, which kept the Marlboro brand and other lesser Philip Morris brands. Part of that, I should mention, was the 1998 master agreement where the big manufacturers agreed to pay $200 billion over 25 years to the states.

11:48I think that continues to this day. $9 billion a year or something is paid out as part of this agreement. One of the big changes that that agreement resulted in was the split off of Philip Morris. So today you have, from a combustible standpoint, you have still Altria as the number one US company and then a strong number two is BAT. And Philip Morris is the biggest competitor elsewhere. And certainly in terms of next generation products, their Icos brand is the largest and actually recently passed Marlboro for them as their largest brand. There was a lot of interesting dynamics there that I want to hit on in terms of branding when it comes to these companies at the highest of level, but also the individual brands as well.

12:30But one thing that you mentioned throughout that history was the involvement of government, the involvement of regulation, a few key milestones there in that history. Can you just give us a sense of what the industry looks like in terms of regulation today, whether it's the taxing, the limitations on advertising, anything else that you can point to because it's a much different playing field when it comes to tobacco products versus others. The biggest thing is the companies are basically not allowed to advertise in the US or in most developed countries, whether that's on TV or radio or print or really anywhere.

13:12They're really banned from advertising. In some ways, that creates sort of a stagnation amongst these brands, which from a business perspective, think, well, stagnation might not be such a great thing. But stagnation, if you're the number one or number two company, is not such a bad thing, right? Because it's basically a guarantee that there won't be upstarts trying to break into this industry. The idea of trying to create a new cigarette brand, I mean, I would guess you'd get laughed out of a room if you try to pitch that to a venture capitalist, because it's just such an obviously terrible idea.

13:49You can't advertise the declining population of users. There's going to be all sorts of pushback. And so it's just simply not possible. And it is taxed very heavily, primarily by the States, at least in the US. And of course, internationally, there's various tax regimes internationally, but like a big chunk of the price that you actually pay for a pack of cigarettes at the store is actually tax money. I've read somewhere, I think the industry was $800 billion -ish within the past few years in terms of total market size, and 25 % of that was going to taxes. So immediately out the door. Yeah, that sounds about right.

14:30Quite a unique dynamic when it comes to operating a business. On the market size, and just some of the trends that you mentioned there in terms of people that actually buy cigarettes today. It's a much different era than what it was like when actors and actresses were seen everywhere with cigarettes in their hand. It was almost a status symbol, in addition to the product being hard to quit. What has that trended like in recent years? And you can split that up however you like if you want to mention what the new products are doing in terms of total market size. But how has that market size trended, especially recently?

15:08The thing that we have the best data on, and also probably the most interesting dynamics is probably the US. Historically, for British American, what they've seen the past probably five to 10 years on average is low single digit declines in volume and roughly similar net price increases in terms of price per pack, which is a very convenient way to think about the business. And it ends up that the traditional business has been amazingly flat the last few years. Although 2023 was actually a larger down year than some of the past ones in terms of volumes with volumes down roughly 10 % in the US. But prior to that, two, three, 4 % volume declines were common.

15:55And it was actually not difficult for them because of this kind of dynamic of it really being an oligopoly, a lot of brand loyalty. They're historically able to raise prices to offset that pretty easily. Altria had a slide recently that they presented at a conference that showed that they think in terms of the volume of cigarette equivalent packs, if you include basically all forms of nicotine, has actually been growing 1 % per year over the past five years. Because you have this dynamic where the traditional volume is declining, but increasing number of people are using vapes or using nicotine pouches or using some other form of oral tobacco.

16:40On their numbers, they have a 1 % actually growth in volumes in the US. It gets even trickier though, to actually figure out what's going on because around 50 % of the volume in vapes is disposable, non -FDA approved vapes that aren't tracked so easily. Like if Nielsen comes in and says, hey, how many of these vapes did you sell? At that point, they definitely know that they're not supposed to give them data. It's a little bit tricky to figure out exactly what's going on, but rough numbers, it's sort of low. It seems like it's either flat to slightly increasing overall volume with the traditional combustible products falling low single digits.

17:22Elsewhere, it seems like it's outside of the US, except for a few places, there hasn't been quite as quick of an uptake on vaping, for example. And so in a lot of places, volume is kind of flattish. And price increases there can result in actually revenue increases. One other interesting market to talk about is Japan. Because there, you've actually seen almost 30 % of revenues now are coming from next generation, these heated but not burned products, primarily Icos. And that market, the overall market has been growing very low single digits, but the overall market has been growing. That's like another story that I think eventually is going to be told.

18:02And people are going to realize is that as people move to less harmful products, the market may actually grow. We have yet to mention the name Zinn. We've alluded to the pouches. And I know Zinn is not a British American tobacco brand, certainly all of the craze and media headlines. And there's some similarities to what was happening with vaping years ago. But when you frame the actual market sizes or market share split between that traditional tobacco and the new wave of products, you gave some sense for BTI. Do you have a sense for the market overall? Are they a reasonable proxy in terms of their mix?

18:45It kind of depends on exactly what you mean. For everyone except for Philip Morris, they have the highest penetration of, I think it was like 16 % or 17 % in 2023. It's going to be like probably more than 20 % this year in terms of next generation products. And for everyone except Philip Morris, that's a very high number. I think Philip Morris is roughly 30 % of next generation products and going towards 40%. That's sort of ex -China, I think, because China has a huge industry and I don't think they have any significant next generation. Although some of the companies that manufacture these things are actually in Hong Kong, which is kind of ironic.

19:25But yeah, Japan is like almost 30 % share. Europe, it's much lower. In the US and other places, it's 10, 15, 20%. I think Zin is a super interesting case study. I mean, Philip Morse is guiding for 60 % volume growth. And I think what people are discovering is that obviously people have known for thousands of years that nicotine is kind of an enjoyable drug to consume. And what the companies are realizing that is that if people can do it in a way that's less harmful, there's just going to be much more demand. So I think that is maybe the canary in the coal mine for kind of the long -term growth of the industry.

19:59And PAT's Zin -like brand in Europe, which is Velo, grew 35 % last year. And I think it has a good chance to continue on sort of a Zin -like trajectory across Europe and maybe eventually the US. They have a Velo 2 .0 product that they're going to be launching in the US at some point once it gets approved, but it's not approved yet. With something like pouches, it's something where, I mean, almost 20 years ago at college, I would go to a party and there would be some rep from a tobacco company giving out these pouches for free. So they were around then. Can you point to what has actually led to the inflection of interest and the demand?

20:39I think it's a combination of things. I think one is back in the day, back when we were in college, the modern oral products had not been released. So there was like snus products that were basically pouched tobacco products. Actually, within tobacco products, there are cancer -causing chemicals. It's not just burning it in your mouth. They're called tobacco -specific nitrosamines. I hope I'm pronouncing that right. And while it's definitely a lower risk product for sure, relative to inhaling a bunch of smoke, there is definitely risk there. A lot of that risk I think goes out the window with the modern products, which are just pure nicotine in a pouch.

21:24And most of those did not get released until around 10 years ago. So there was that. And then I think also similar to the popularity of vaping in the US, Once you have a product that is a purified nicotine, it's not tobacco. It doesn't have inherently any sort of tobacco flavor. You can put other flavors in it. So you can have a mango zin or a mint zin or whatever. And that's just, I think, inherently a more desirable product than a tobacco flavored pouch. So I think it was a combination of those things, the health aspects and the ability to more easily put in flavors that probably is causing the growth in the business.

22:05And then in terms of those products and the regulation around those, it's interesting because it seems like Zinn was an upstart or part of a much smaller company before being acquired, which shows that there can be this path for new products outside of the traditional cigarette space. Are they regulated significantly differently in terms of whether you can advertise for them or anything else along those lines? Zinn is basically regulated similarly to any other tobacco or nicotine products. They're not allowed to advertise. They're not allowed to do all the things that a normal company could do in terms of marketing the products, which honestly makes its growth all the more amazing.

22:46It's not even fully approved, actually, in the US. There's sort of like two buckets of these reduced risk products, or it's actually three buckets. One bucket is actually approved products, which I think views, enjoy, and self -serve e -liquid products where you have your own personal tank and you refill it, etc., which is like a tiny percentage of the market. Those products are actually approved. And then there's a chunk of products where they are not approved, but they're still in litigation and the courts have said that it's okay for them to be sold. Zinn is one of those. And then there's a whole group of products that are actually not approved and not under any type of holding pattern where they're still allowed to be sold.

23:29That applies to pretty much all of the disposable vaping products in the US. Are there limits on distribution as well? Because when I think of where you can actually buy cigarettes, gas stations and airports, duty -free areas, are there other key distribution points for these businesses? I think as far as I know, you know, you just have to, the retailers have to be licensed. And typically, so the regulations are basically similar to traditional tobacco products. You have to have like a license to actually sell it. Arguably, the distribution prowess of Philip Morris is actually, is, you know, what some people point to as sort of fueling the growth of Zyn in the US over the last few years.

24:21Getting to the point of brand, which you mentioned, there's a lot of brand loyalty from centuries ago. You mentioned names like Camel and Marlboro. But when you flash forward to today, when you have a product like Zyn and you're trying to compete with that and the media coverage that it's getting, which is in some ways likely to just attract more attention to potential users, unless there's actually regulation in force. How does a business like British American Tobacco try to get more loyalty towards their own brands and their own products? In the US, they've had a really tough time breaking into Zinn's stranglehold on the US market.

24:59And if anything, when people ask, because sometimes there's some pushback around sort of the brand loyalty of vaping, for example. People think that people will just use whatever product. But if you look at Zinn, I think what Zinn shows is that once brands are well -established and people start using the same thing and they like it, it's actually pretty tough to break into that stranglehold. And so what British American Tobacco has done so far is actually refocused on the markets where they're the Zen, which is most of Europe that has sort of a material modern oral business. They're by far dominant in the Scandinavian countries, for example, which is where the product originated.

25:43I don't think they've explicitly said this, but I think that they're waiting for the approval of their Velo 2 .0 products in the US before they really put marketing dollars behind it. Because that's the product that they're selling in Europe. That's the best product. And so they have the Velo 1 .0 here, but not the 2 .0. And so I've actually heard of Canadian hockey players that import this Velo 2 .0 product from Europe. They like it better than Zinn, supposedly. And that might just be me searching for a sign of an anecdote that matches my bias. I think it's a good sign for the long -term ability to compete.

26:20That anecdote, I think, is just interesting in this day and age in terms of who influences the purchase of things and avoiding the word influencer, particularly in an industry where advertising is difficult. You did mention the distinction there that they would spend marketing dollars. Can you just differentiate what marketing dollars mean when advertising is so restricted? It's primarily in discounts to retailers. You can also put people out into the field. You can put physical bodies out there to carry packs of Velo and say, go to convenience stores and say, hey, you should be selling this, that have better product placement, etc.

27:00You can have them put something in the window of the convenience store or whatever. You can pay for that type of advertising. That's common. Almost giving the retailers free products is one of the common ways that they spend marketing dollars. There's an interesting category of businesses where I think you see that you see the reps on the field. Again, I'm going to bring up the college party example where Red Bulls and pouches were not too uncommon to see out there. In Europe, what Icoast did, which was genius, was they would have sponsored events. I think they still weren't allowed to traditional advertising in many places, but they would sponsor events.