British American Tobacco: “Washed-Out” Selloff Unveils A Golden Buying Opportunity

British American Tobacco or BAT (NYSE:BTI) investors endured significant volatility over the past week, as management stunned the market with a substantial writedown in its recent pre-close trading update for 2023. I last updated BAT investors in August 2023, assessing a double-bottom opportunity leading to a sustained bullish reversal of its downward bias. However, that thesis was tested as sellers broke down BTI’s preserve zone toward the $28 level before buyers returned.

Accordingly, BAT decided to register a non-cash impairment charge on its balance sheet for 2023, amounting to about GBP25B. The non-cash adjustment is “related to assessing the carrying value and useful economic lives of some acquired US combustibles brands.”

In its pre-close conference call, management clarified that BAT’s long-term capital allocation framework isn’t expected to differ due to the non-cash adjustment. In addition, investors shouldn’t expect changes from the company’s ongoing effort to reduce its adjusted EBITDA leverage ratio to 2.5x from its forecasted 2.7x for 2023.

However, BAT accentuated that “the value of these (US) brands cannot be justified at their current level on the balance sheet in the long term.” As a result, management believes it needs to make the necessary changes to its accounting treatment of these brand assets, “changing from indefinite life to finite life (30 years).” The company expects to start amortizing the value of these brands from January 2024.

Analysts have mixed views (see here and here) on the long-term outlook for BAT, although the market’s view on its stock over the past year is clear, given its significant underperformance. Accordingly, BTI posted a 1Y total return of -24.2%, much worse than the shares of Altria (MO) and Philip Morris (PM), which fell 3% and 5.7% over the same period on a total return basis.

Given the significant impairment charge undertaken by the company, I believe the market has gotten BTI’s relative underperformance on point, suggesting its valuation was overstated previously.

Management anticipates ongoing investment in 2024, particularly in heated products, part of its next-gen products or NGP portfolio. The company articulated industry headwinds and more intense competition in the heated category in 2023. As a result, BAT anticipates “reinvesting some profits” moving ahead. Despite that, the company is optimistic about the profitability growth inflection in the overall NGP portfolio, projecting a “positive profitability outlook for New Categories in 2024.”

However, these actions are expected to add to the external challenges, including macroeconomic pressures and consumer discretionary spending for 2024. As a result, management informed investors to expect a “low-single-digit growth in revenue and adjusted profit from operations” next year. Notwithstanding its near-term caution, BAT remains confident about continuing its profitable transition to its NGP portfolio over the next three years. Accordingly, BAT envisages a “3 to 5% revenue growth and mid-single-digit adjusted profit from operations growth” by 2026.

My assessment of BTI remains the same. It’s cheap (“A+” valuation grade) and still very close to bottoming out. While the recent price action indicated that the previous near-term reversal opportunity was invalidated, the long-term bullish thesis is far from overturned.

I still see the recovery of BTI’s $32 long-term preserve level as possible, notwithstanding the panic selling that led to its $28 low this week. Based on my analysis, buyers returned with conviction in November 2023, validating BTI’s recovery at the $32 level before the intense selling fervor this week due to the recent management update.

However, I posit that a re-entry signal over the next three to four months predicated on a decisive recovery of BTI’s $32 level remains in play, proving whether BTI buyers are right to preserve the lows we experienced in this week’s selloff.

Takeaway

BTI bears could point out they have nailed their thesis on BAT over the past year. I must give credit when it’s due, and I believe they have convincingly gotten the better of BTI bulls. However, management’s stunning impairment update culminating in a panic selloff this week has also engendered a “wash-out” event.

Several positive factors make this more likely the case, leading to a subsequent bullish reversal over the next few months than a continuation of BTI’s downward bias.

Macroeconomic headwinds are expected to improve. Management has also highlighted that 2024’s adjusted EPS normalization would inflect positively through 2026 as its NGP portfolio trends toward profitability. In addition, management has taken the hard decision to ponder the updated valuation of its declining US brand assets, reflecting market reality as Big Tobacco ramps up its transition toward reduced-risk products. Also, BAT’s long-term capital allocation framework remains unchanged, with more constructive tailwinds to boost shareholder returns when it reaches its targeted leverage ratio.

Investors must still be cautious about catching the proverbial falling knife, as BTI remains in a downtrend. However, I believe the impairment update has helped to compel the weak holders to capitulate, reinvigorating my thesis that the worst in BTI’s reject is likely over.

Rating: preserve Buy.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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