BAT

One of Charlie Munger's famous quote is 

"All I want to know is where I am going to die, so that I'll never go there".

He didn't mean this literally (he recently passed away).  It's actually the same point as Warren Buffet's investing rule no 1 and 2.  What both means is that they want to know where are the investing mistakes that loses monies, so that they follow Rule No 1:  Never lose money.

Unfortunately, BAT is an example of a business that has lost earnings since 2015 peak.  Price crashed and dropped subsequently.  My contention is that it's not yet over.  Some long term price charts first.

LT Price Chart

3 clear phases since 2000:
1. 2000-2015:  Bull run phase running 15 years at least.
2. 2015-2020:  BAT crash phase lasting 5 years.
3. 2020-2023:  Gradual decline phase lasting 3+ years.

Note the greatest fear with highest volume happened around 2020, and there's a small opportunity to buy when everyone else is running at capitulation stage - however, this is not investing strategy, and capitulation play is a completely different trading strategy.  (A side note is in comparison to 2020 high volume, today's volume is tiny in comparison and is no longer a rewarding capitulation play).

Business Quality - last 10 Years

It's clear from above, that the highest EPS and DPS per share from BAT happened in FYE2015.
- This corresponded to BAT peak price around RM70.
- Since then, BAT EPS has declined from 319 sen down to 73 sen or roughly 4.5 times.
- BAT DPS follows EPS decline, as the company endeavours to pay out nearly all of its earnings.

Price generally follows earnings and dividend contraction, except, here, it has fallen more rapidly, because of P/E multiple contraction, from 20-25 down to 10-15.  My contention is that this P/E of 15 is still quite generous and can shrink further.

BAT's business model

This relates to the question - what caused BAT's earnings crash since 2015?

Sometimes you may hear illicit cigarettes being used as a reason.  This is actually not a new factor - e.g. Read 2015 BAT annual report, and so, is only partially true.  Partially because whilst it has gone worse by anecdotal accounts, illicit also means that the government data collection process is more vague, less disciplined, and more prone to hearsays.  Just because more and more people start calling a dog's tail to be a leg, it doesn't mean the dog now has 5 legs.  The dog still has 4 legs.

"The operating environment in 2015 was far tougher in terms of business challenges in comparison to previous years. The escalating illegal cigarette trade was the main challenge faced by the legal tobacco industry. One in three cigarettes in Malaysia is illegal which puts the illegal cigarette trade incidence at a high 36.9 percent , a 3.2 percentage point increase from 2014." 

The second factor is cigarette alternatives (such as e-cigarette, vaping, etc.).   Google the history of e-cigarettes and we know it was already around in early 2010s, when BAT price keeps rising.  It appears BAT has under-estimated this threat, because as late as 2020 (e.g. look at 2019 BAT annual report), it still keep blaming illicit cigarettes.  Look at the cover of the annual report and the Chairman messages:

Of course the rest since 2020 is history.  

Whatever the cause (blame never helps), BAT was slow to respond to the growing threat of alternatives.  

Using Vaping as example, Malaysia vape users rose to 1.4 million in 2022, out of 23 million adult population in Malaysia - if true this is roughly 6%.  Total cigarette users % adults in Malaysia is around 23% in 2015, estimated by the government.  

If true, this suggests 5 million adult Malaysians smokes.    

Doesn't take a genius to figure out that there is still considerable substitutions to be had in the coming 10 years.  From a total population perspective, perhaps 3.5-4 million Malaysian cigarette smokers could potentially still switch.  Half of them are expected to be BAT customers (since it has 51% market share).  So, there are still millions who could still switch to vape in the coming 5 to 10 years.

Relative revenue/profitability between traditional cigarettes vs Vuse

Vuse is BAT's top vaping product on sale, and they are clearly late in introducing this product to Malaysian market.  

It appears one could buy a pack of Vuse GO 3000 (good for 3000 puffs) online for approximately RM26.

Compare to a pack of Dunhill going for apparently RM17.40-17.70.  Depending on the smoker, a single pack may be good for 200-300 puffs, say 250 puffs.

What does this mean to BAT revenue per smoker who switched from Dunhill to Vuse GO 3000?

To get 3,000 puffs from normal cigarettes, the typical smoker will need 12 packs.  Estimated Revenue = 12 x 17.40 = RM209.

The same company offers 3000 puffs for RM26 via Vuse GO 3000.

The potential for revenue contraction (from RM209 down to RM26) is nearly 88% per smoker.  Let's say at least 80% revenue contraction every time a smoker switched.

Current BAT market share

In BAT's latest 2022 Annual Report, they claimed that they still have 51.6% market share, presumably vast majority are cigarettes.

This is disturbing to BAT's future revenue prospects over the next 10 years.

Considering it holds half of 5 million smokers, say 2.5 million smokers, and its share of Vuse GO smokers is unlikely to be larger than 25,000 to date, due to slow start i.e. unlikely to be 1%.

And even if it's successful to recapture previous smokers and turn them to Vuse GO, it is likely to lose the majority of its revenues.

Therefore, it is unlikely that we've seen the bottom on BAT declining EPS even today.  If you consider how many years it would take to switch a generation of population to change behaviours, this is a long term pattern and it's quite unlikely that we've seen stabilization / bottoming.   

If so, over the next 5-10 years, it is quite likely that we will continue to see BAT EPS continue its decline notwitstanding quarterly spikes (which can be engineered by clever management). 

Side observation - brilliant management vs bad economics

When reading BAT's annual reports since 2015, it is interesting to note how many times BAT has changed its CEO - I counted at least 4.  Over this period, all 4 are expats.  What does this mean in the context of Buffet's quote:  "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Simply put, giving these expats the benefit of the doubt that they are brilliant management, the fact is that eventually, these CEO has to leave BAT Malaysia without turning around its EPS, because when they go against bad economics, it is the reputation of BAT's bad economics that remained intact.   Simply put, EPS continued to decline, management continue to change.   We should not underestimate how poor BAT's economics are.

A second potential reason why frequent management change is bad for business.   The replacing CEO knows that he/she may only have a short time - say 1 or 2 years to turnaround the business.  Therefore, if a business decision needs 3 or more years to show fruition, it is quite unlikely for this CEO to consider implementing, because he'll be gone by then, and any benefit only to be gained by his replacement.  This is another constraint to overcome, one caused by bad economics.

Conclusion

One of Buffet and Graham's famous quotes are:  "In the short run, the market is a voting machine, but in the long run, it is a weighing machine.".  What this means is in the long run, the stock price tend to follow earnings and in the case of BAT, as its price falls and as its future prospects fall, its P/E multiple also falls together with its EPS, causing a faster than proportionate fall in its Price.

Today, it is still being priced on a 10-15 P/E multiple.  

If BAT revenues continues to shrink over the next 5 years, then, it is possible that one day we'll see P/E contraction in addition to EPS contraction i.e. the current price between RM9-9.50 may not be the bottom yet.

For investors, this is a sunset industry and best avoided for now.  Compare to MAYBANK benchmark, the difference is huge.

Remember Buffet's Rule No 1 and 2.  To avoid making long term investment mistakes, remember Munger's opening statement above, with Dividend Guy paraphrase - "all I want to know is where and how I will lose monies, so that I avoid going there"

Instead, look for businesses with above average / superior economics for longer term investments.  We don't lose monies when we don't invest in bad economics stocks.