British American Tobacco’s move to smoke-free: progress made, but cigarette decline persists

Like all cigarette manufacturers, British American Tobacco (BTI -0.34%) it has one really big problem: its core product is cigarettes. They are working to reduce reliance on this declining product category, but there is no easy fix. Here’s what the company has done so far, and why it still has miles to go before cigarettes aren’t the most important product it sells.

How bad is the cigarette problem at British American Tobacco?

When British American Tobacco reported earnings for the first half of 2024, CEO Tadeu Marroco opened with this comment: “We are building a smoke-free world. We added 1.4 million consumers (to 26.4 million) from our smoke-free brands, now representing 17.9% of the Group. revenues, up 1.4 percentage points from FY23.”

Image source: Getty Images.

However, if around 18% of revenue comes from smokeless products, then the remaining 82% comes from traditional tobacco. In this category, cigarettes are the driving force. So when it comes to the top and bottom lines, cigarettes are clearly still making the decisions.

With that in mind, cigarette volume fell 6.8% year-on-year in the first half of 2024. Other fuels fared worse with volumes down 12.6%. Fortunately, other fuels — such as cigars — make up only 2% of the volume. Still, these trends are worrisome, and the company largely acknowledged the challenge last year with a major accounting shakeup.

In 2023, British American Tobacco received a massive impairment charge, writing down the value of its US operations. Management also announced a decision to amortize the value of its US cigarette brands over a period of up to 30 years, a tacit acknowledgment that the long-term viability of this business is unknown.

New categories are where the future lies for British American Tobacco

Management clearly isn’t burying its head in the sand, with around 18% of revenue coming from smoke-free products, but the news isn’t all good here either.

For example, the company’s growth engine on the non-cigarette side falls into a division called New Categories. This group represents 13.3% of revenues. This is where British American Tobacco puts most of its effort, or so you’d expect. Revenue in the New Categories group was down 0.4% year-on-year in the first half of 2024. However, revenue was up 7.4% on an “adjusted organic” basis, which excludes:

(E) the performance of businesses sold (including the Group’s businesses in Russia and Belarus) or acquired, or having a lasting structural change affecting performance that may materially affect users’ understanding of the Group’s performance in the current and comparative periods to also ensure similar valuation in all periods.

The first half of that note makes sense. The second half (sustainable structural change) is quite open. Stripping some businesses from comparable results can make sense given that this is essentially a division full of established businesses — some of which are products that simply didn’t exist before. It is reasonable that progress may be slow and some investments may fall by the wayside.

But when you dig a little deeper, oral pouches were the only New Categories product to see year-over-year volume growth during the period. That growth was a whopping 50%, but with volume declines in the other four major products in the New Categories group, it doesn’t look like a resounding strategic success.

British American Tobacco is doing well, but there is still tons of work

This is not meant to suggest that British American Tobacco is doomed or that the company is failing in its effort to quit smoking. It’s meant to temper any enthusiasm investors may have after bidding the stock up about 25% over the past three months. Also, keep in mind that the massive 7.6% dividend yield may not be as reliable as some long-term investors think.

With a lot of work to do on the non-smoking side of the business, British American Tobacco is still a fairly risky dividend investment. Investors should proceed with caution.