British American Tobacco

British American Tobacco presented an updated strategy at its capital markets day, but most of it was unchanged. BAT expects to drive growth from new categories while extracting robust free cash flow generation from its combustibles business.

Why it matters: Shares declined 2% on Sept. 29 as the market may have expected upgraded guidance. Instead, the company maintained its midterm annual average growth targets of 3%-5% for revenue, 4%-6% for adjusted operating profit, and 5%-8% for adjusted diluted EPS. For 2026, BAT continues to expect to hit the lower end of its revenue and adjusted operating growth ranges. This outlook reflects near-term regulatory headwinds in Australia and Bangladesh, unrelenting economic pressure on consumers, and heightened investments in new categories. BAT has had success in closing the gap with wide-moat peer Philip Morris, especially in nicotine pouches. For example, in the US, BAT has captured roughly 80% of industry growth to reach 30% market share and become the second-most popular brand. However, promotion is a major driver.

The bottom line: The capital markets day presentation reaffirmed most of our outlook, so we maintain our forecast and our fair value estimates of GBP 4,700/$63 for wide-moat British American Tobacco. Shares have declined 10% since the beginning of August, underperforming most tobacco peers. We think shares are undervalued, as we think the market is overly concerned that BAT will fail to reach the lower end of its midterm growth algorithm for the foreseeable future. We forecast average annual growth of 3% for revenue and adjusted operating profit (the latter slightly short of guidance). We think that market price-implied expectations underestimate top-line growth from new categories and easing promotions and scale that should drive margin expansion.

BLANK PAGE

After incorporating British American Tobacco's first-half 2026 results, we’ve raised our fair value estimate to $63 per share from $58. The increase is driven by a more constructive outlook on BAT's reduced-risk portfolio, reflecting an increase in our terminal EV/EBITDA multiple assumption to 7.5 from 7.3.

We assume an exchange rate of $1 per 0.74 British pounds as of July 30, 2026. Our valuation implies a 2027 price/adjusted earnings ratio of 12 times, enterprise value/adjusted EBITDA of about 9 times, and more than 5% dividend yield. These multiples are at the middle of the tobacco peer group, reflecting decent long-term growth from its diversified portfolio of next-generation products offsetting declining combustibles.

British American Tobacco announced that first-half revenue grew 3% in constant currency and that adjusted operating margin expanded 30 basis points to 43.7%. Reduced-risk revenue grew 17% (now 16% of total), primarily driven by its Velo nicotine pouch. In the US, Velo has reached 31% and 26% of volume and value share, respectively, in nicotine pouches from the success of Velo Plus. As Philip Morris launches new flavors and the Zyn Ultra line, we think the Velo Max launch should help BAT remain competitive in this fast-growing market.

We forecast cigarette volumes to decline more than 4% annually through 2030, slightly lower than the industry decline. BAT’s presence in midtier and discount categories helps blunt some of the decline as it can capture consumers trading down. We expect mid-single-digit price increases as well as incremental revenue from next-generation products to offset the volume declines and lead to nearly 3% annual revenue growth in aggregate. This compares with the mid-single-digit top-line growth we forecast for PMI, which benefits from its lead in heated tobacco and nicotine pouches. Indeed, we expect cigarettes to generate most of BAT's revenue in 2030 at 73%, down from 79% in 2025. We forecast its adjusted operating margin (as defined by the company) to rise to 46% by 2030 from 45% in 2025, as continued investments in reduced-risk cap margin expansion.

Beyond our five-year explicit forecast, we assume a terminal EBITDA multiple of 7.5 times to value future cash flows, based off medium-term growth of 1% and a long-term decline of 3%. We refrain from using Morningstar’s standard methodology given the long-term secular decline of tobacco. Our multiple is in the middle of the range of our coverage, reflecting our view on BAT’s position in next-generation products.

We explicitly include one ESG risk within our forecast, as we expect the adverse health effects of tobacco and nicotine to lead to long-term consumption decline.

We assign British American Tobacco a wide moat rating based on intangible assets and cost advantage.

We forecast ROICs averaging 12% over the next five years, well above our estimate of its weighted average cost of capital of 8%. However, ROICs excluding goodwill average about 22%. We argue that this metric is more relevant, as the transformative acquisition of Reynolds Americans in 2017 added GBP 110 billion in goodwill and intangible assets (mostly trademarks). We see another major deal like this as unlikely and thought the price paid was not value-destructive. BAT already owned 42.2% of the firm, so we think that portion of the acquired goodwill and intangibles represented a step-up on already owned shares. Prior to the acquisition, the stake was listed for GBP 8 billion in 2016.

First, tobacco contains nicotine, an addictive substance that keeps customers coming back and suppresses the cessation rate despite adverse health effects. According to Tobacco Atlas data, more than 60% of all smokers intend to quit, and 42% have attempted to quit over the past 12 months. Yet in most markets, the smoking rate is only in a very modest decline, implying that most attempts to quit fail. Academic research (Lewis and others, 2015) has shown that while cessation rates are not correlated with consumer brand loyalty, premium price segments are associated with lower cessation rates. BAT has a balanced cigarette portfolio with around one-fourth of volume in premium, one-third in midtier, and the remainder in discount.

Moreover, consumers exhibit brand loyalty. One academic study (Nogueira and others, 2018) found that 86.6% of smokers had a preferred brand, with 44.4% saying they had a “lot of” loyalty to their brand. Far more stated taste (83.2%) rather than price (51.7%) as driving their preference. This is even though blind taste tests have observed that most smokers cannot distinguish brands (DeCicca and others, 2021). The addictiveness and strong brand loyalty lead to robust pricing power. As evidence, BAT’s combustibles revenue declined 2% annually from 2020 to 2025 while volume declined 6%.

We believe that regulations have entrenched market leaders. Tobacco advertising is severely restricted in most markets, with bans on most forms of mass marketing. This makes it difficult for new entrants to gain the attention of smokers and damps competition among incumbents. Volume shares have been very stable for decades, primarily, we believe, because the lack of marketing has discouraged switching. PMI has been the only cigarette maker to increase its market share organically—but by just 30 basis points—on a global basis excluding China since 2008. On average, consumer products manufacturers in more competitive categories spend roughly a high-single-digit percentage of sales on marketing. Big Tobacco manufacturers have historically spent a low-single-digit percentage of sales on advertising (although we expect next-generation products to require greater spending). Some other regulations may also have had the unintended consequence of limiting competition in price and creating a barrier to entry. Point-of-sale display bans create a disincentive to engage in promotional strategies.

In the US (45% of 2025 sales), the Food and Drug Administration has imposed restrictions on marketing new or modified products. Tobacco products introduced or modified after March 22, 2011 (Aug. 8, 2016 for some small tobacco categories) require premarket review by the FDA unless the manufacturer can prove that the products are “substantially equivalent” to products commercially available on Feb. 15, 2007. Products or modifications deemed not to be substantially equivalent may only be brought to market in the US following FDA review and approval. The substantial equivalence rule makes it difficult for new entrants and reduces the financial burden of investing in new products that is critical for other consumer industries. It is also significant that participating manufacturers are due a rebate on a proportionate amount of their Master Settlement Agreement payments should their market shares fall below a threshold set from 1997 levels.

BAT is the third-largest cigarette manufacturer in the world, with an annual volume of 485 billion. This trails Philip Morris International’s 607 billion and Japan Tobacco's 564 billion but exceeds Imperial’s nearly 187 billion and Altria's 62 billion. We think cigarette manufacturing enjoys economies of scale benefits given product homogeneity. We estimate BAT’s operating cost per pack at $0.47, roughly in line with PMI’s and JT's $0.49, but below Imperial’s $0.59 and Altria's $0.88.

Despite secular cigarette volume decline, we remain confident that BAT’s competitive advantage can last for the next 20 years. BAT’s pricing power has allowed it to offset the volume decline. We expect there is a tipping point at which price elasticity would increase. For example, in Australia, since 2011, tax increases doubled the retail price of cigarettes in just six years, which in turn led to the smoking rate falling from 16% to 13%. A pack of 20 cigarettes (equivalent; a standard Australian pack contains 25 sticks) now costs approximately $40, according to a survey by Tobacco in Australia, well above the roughly $21 average retail price in the UK, $10 in the US, and roughly $4 on average globally, according to the World Health Organization. Assuming 4% annual real pricing increases, it will be into the 2060s before pricing reaches levels at which elasticity increased in Australia.

The threat of material value destruction is of low probability, in our view. For example, in 2022, New Zealand passed a law that effectively banned anyone born in 2009 or later from purchasing cigarettes for life. A new government repealed the ban in 2024, arguing that prohibition would lead to the rise of an illicit market. We believe future regulation is likely to be incremental rather than bans.

The acquisition of Reynolds American gave BAT arguably the second-best position in the US cigarette market, a high-margin market with headroom to raise prices and optionality in the heated tobacco market.

BAT generates meaningful revenue across continents, giving it diversification against individual countries’ regulatory risks and changes in consumer preferences.

With three-fourths of its volume in midtier and discount categories, British American Tobacco could benefit from trading down if consumer wallets continue to be stretched thin by inflation.

British American Tobacco’s leadership in vaping matters leaves it exposed to the massive threat from the illicit market in that category.

Given its greater potential as an alternative to cigarettes, Philip Morris International’s lead in heated tobacco is a significant disadvantage that BAT will be unable to narrow.

BAT’s international exposure creates significant currency risk given much of its debt is denominated in US dollars. A strengthening of the US dollar can hurt its ability to service its debt.