British American Tobacco: No Smokin’ Performance

Like the McLaren F1 team it sponsors, British American Tobacco is having a hard time winning races. The most important race in the tobacco industry nowadays is the one to sell nicotine products that are less harmful than cigarettes. BAT is certainly one of the more serious contenders, but its recent results show it is still miles behind the leader Philip Morris International.  

Adding urgency to the outcome are the regulatory pressures encircling the tobacco industry around the world; financial markets have slapped a heavy discount on most tobacco companies as a result. As PMI’s market premium suggests, selling less risky products is rewarded with a higher valuation. Hence the importance to BAT to compete effectively in selling reduced-risk products. 

Its disadvantage in this area is largely the result of decisions made many years ago. While PMI invested heavily in heated tobacco products a decade past, BAT relied on a more cautious next-generation strategy that relied heavily on vaping products. As a result of this dual track strategy, BAT failed to match PMI’s heated tobacco technology and was caught on the wrong foot when heated tobacco products took off in Japan around 2016-2017. The British company has been struggling to narrow the gap with the market leader ever since. Case in point; whereas BAT sold roughly 24 billion heated tobacco units last year, up by 26% versus 2021, PMI is selling more than that each quarter.

Heated tobacco volumes by company 2016-2022. BAT has expanded its heated tobacco volumes more quickly than PMI in recent years, but has so far failed to meaningfully narrow the gap with the market leader

BAT has certainly worked to improve its heated tobacco product line-up available to consumers, including being first-to-market with an induction-heating device, but the volume gains it has booked have been incremental instead of exponential. Contrary to what I thought previously, this suggests the gap with PMI is unlikely to narrow meaningfully. BAT’s products have shown particular traction in the lower income markets of eastern Europe, where PMI’s premium-priced devices and sticks can weigh heavily on disposable income. Russia’s invasion of Ukraine in 2022 has not helped BAT in this regard; the company was showing significant momentum with heated tobacco products in both markets before the war, but the outbreak of hostilities and the ensuing public outcry against Russia have effectively ended its heated tobacco sales in both markets. BAT has committed to withdrawing from the Russian market completely, although the disposal of its operations has not taken effect yet. 

Meanwhile BAT’s bet on vaping products has so far failed to pay off; while the company has managed to secure a leading position in almost all of the largest vaping markets outside of China, the uncertainty regarding regulatory interventions and unattractive product margins have so far kept its product from delivering reliable profits. The most important problem with vaping products is that they tend to attract young consumers, not seldom minors, which causes all sorts of problems with parents, politicians and regulators. Case in point is the political backlash against teen vaping in the US, which effectively knocked market leader Juul off its pedestal in that market. Who is to say what will happen to BAT’s product Vuse, which took the lead from Juul during 2022? After all, most Vuse products, including the best-selling Alto, have not received regulatory clearance from the FDA, which has so far failed to authorize any vaping product with a non-tobacco flavor. Any marketing denial orders issued by the FDA could easily upend the market once more.

At the same time, heated tobacco products attract far less regulatory scrutiny because they mostly attract current smokers, which makes them less controversial than vaping products. They also attract far less competition, in no small part because the development of these products is prohibitively expensive and also because very few companies desire to enter the controversial tobacco business. The result is that the market for heated tobacco products is far more concentrated and thus far more profitable than the vaping market (excluding China). 

Market leader Philip Morris Intl. is meanwhile working hard to defend its leading position; its IQOS product is the only heated tobacco product with an FDA-approved premarket tobacco application (PMTA) in the United States, and it has recently come into possession of a sizable US subsidiary through its acquisition of Swedish Match. Now that it has a product, regulatory clearance and a distribution platform lined up, the company is preparing to relaunch IQOS in the United States in 2024. 

Rather inconveniently, BAT’s premarket application for its heated tobacco product glo is still languishing inside the overworked FDA bureaucracy, with absolutely no visibility on the regulator’s review timeline. It therefore looks increasingly likely that the fight to convert US smokers to heated tobacco products will be a replay of what happened in Japan; Philip Morris will have an extended period during which it will have the market entirely to itself. The latecomers will be left to battle over any scraps. This time it might be more painful for BAT; roughly half its global profit is derived from the pool of US smokers PMI is looking to convert.

Disclaimer: the author had no positions in any of the companies mentioned in the article at the time of publication.