Description

Overview

Tobacco stocks have been strong long-term performers. According to Credit Suisse, $1 invested in the tobacco industry in 1900 turned into $6,300,000 by 2010, for a 15.3% IRR over more than a century. Tobacco was the single best-performing industry in Credit Suisse’s study. Altria is the tobacco stock with the longest return data on Bloomberg, and it has returned 869x from 1980 through today for a 17% IRR. British American Tobacco has returned 21x from 1998 through today (again as far back as Bloomberg has data) for a 13% IRR.

Tobacco companies possess several characteristics that made them good businesses over the long run. These include strong brand loyalty, high barriers to entry due to regulation, and low capital intensity which leads to high returns on capital.

This writeup recommends a long position in Pakistan Tobacco Company LTD (PAKT), which is the listed subsidiary of British American Tobacco (BAT) in Pakistan. The current price on exchange is 722 PKR/share; however on-screen liquidity is negligible and the most recent sizeable blocks have gone through at 540 PKR/share in off-market trades. The most recent ~7.5m USD trade at 540 PKR/share was on August 3, 2023 and can be viewed in the “off-market transaction” page for that date in this link: Downloads - Pakistan Stock Exchange (PSX)

540 PKR/share equates to 5.2x 2023 PE and 1.9x EV/EBITDA, and should come with a ~19% annual dividend yield. 

We believe the overall return when purchasing at this price will be very favorable. It will depend on the change in PAKT’s earnings, P/E multiple, and dividend yield.  Let’s review each of these three in turn.

PAKT Earnings Potential

PAKT sells 43 billion sticks of cigarettes per year in Pakistan. Just under 12 billion sticks are sold by other branded, legal manufacturers (mainly Philip Morris Pakistan), while 32 billion illicit (non-tax-paying) cigarettes are sold per year. So, PAKT has a 78% market share of the legal market, and a 50% market share of the entire cigarette market. Pakistan’s tobacco market is large as the country has 235 million people.

To give you an idea of PAKT’s scale, consider that the 43 billion sticks it sells annually equal exactly half of Altria’s 86 billion sticks of sales. Altria supplies 48% of the cigarette market in the United States, is expected to bring in 9 billion USD in net income in 2023, and has a 103 billion USD enterprise value. PAKT (with half of Altria’s cigarette volume) should earn around 93 million USD in net income in 2023 and has a 282 million USD enterprise value. Thus Altria has 2x the volume but ~100x the net income and 365x the enterprise value of PAKT (using the PKR 540/share block price).

The reason for this is straightforward: Whereas the price of a pack of cigarettes in the United States varies from 5.00-13.00 USD depending on the state, PAKT’s cigarettes retail for 0.48 USD on average. Pakistan is a low-income country, with GDP per capita of 1,600 USD in 2022. Given their incomes, Pakistanis cannot afford the higher cigarette prices charged in other countries like the United States. Over time as Pakistanis grow wealthier, PAKT will raise prices. Demand for cigarettes is famously price inelastic, given their strong consumer attachment.

During 1960-2022 real GDP per capita (in constant USD) grew at a 4.9% CAGR, with nominal GDP per capita compounding at ~8%. Pakistan will not become as wealthy as the United States anytime soon, but the trend for Pakistani incomes—and therefore for Pakistani cigarette prices and PAKT’s earnings—is fairly consistently upwards.

Below we can see that PAKT’s financials are trending well recently, with profits growing from 19 million USD in 2012 to 106 million USD in 2022.

While Altria’s earnings levels remain far away, nearer-term milestones provide a sense for PAKT’s earnings prospects. ITC, the tobacco leader in India, sells 70 billion sticks per annum—60% more than PAKT’s 43 billion. ITC’s cigarette business earned 2.2 billion USD in EBIT in 2022, or around 1.43 billion USD in net income. If we divide by 1.6 given ITC’s higher volume sales, this equates to PAKT earning net income of 875 million USD—around 9x PAKT’s current level. This is also more than 3x greater than PAKT’s enterprise value of 282 million at the block price, indicating clear multi-bagger potential. India has GDP per capita of around 2,400 USD, a level that it is perfectly realistic for Pakistan to reach within the decade. ITC’s massive profits in India indicate that it is reasonable to expect PAKT’s earnings to aggressively grow upwards from the current 106 million USD as PAKT raises cigarette prices. Earnings for PAKT are very sensitive to changes in cigarette prices, as the incremental revenue involves no associated costs and drops straight to the bottom line.

Ceylon Tobacco (CTC), BAT’s subsidiary in Sri Lanka, is another example. Sri Lanka is a much smaller country than Pakistan and CTC sells just 2.8 billion sticks per annum despite being the clear market leader. CTC’s volumes are 1/15th of PAKT’s volumes, yet CTC made 72 million USD in net income in 2022. The reason is that the average selling price of a pack of cigarettes in Sri Lanka is 3.20 USD, significantly higher than the 0.48 USD for PAKT’s packs.

Multiplying CTC’s net income by 15x indicates that at CTC’s price levels PAKT would earn 1.1 billion USD in net income—~12x current levels. 1.1 billion USD is also 4x greater than PAKT’s current enterprise value of 282 million, indicating clear multi-bagger potential. GDP per capita in Sri Lanka is 3,300 USD, about double Pakistan’s current 1,600. Recall that nominal GDP per capita for Pakistan has been growing at an 8% CAGR since 1960. So, it may be realistic for Pakistan to reach Sri Lanka’s income levels in ~10 years. CTC’s financials imply that PAKT could earn 1.1 billion USD in net income then, which is massively higher than today’s 106 million USD. CTC’s substantial profits in Sri Lanka on very small volumes suggest it is reasonable to expect PAKT’s earnings to grow rapidly from today’s levels. It is worth noting that Sri Lanka is currently going through a severe financial crisis - this benchmark for PAKT's profitability is with a country in serious financial difficulties.

Predicting PAKT’s future earnings with any certainty is challenging. But we think it is useful to bear in mind that Pakistan is a very large country of 243 million people, and 43 billion is a lot of sticks to sell. PAKT currently earns 93m USD in profits now but simple thought exercises indicate this will increase meaningfully as Pakistan’s GDP per capita increases and PAKT correspondingly raises cigarette prices.

Valuation

We have believed for years that PAKT has a strong earnings outlook. The reason we are writing this up now is that there has been a collapse in PAKT’s valuation. See below PAKT’s share price over the last decade.

The stock was bid up starting in 2013. Since 2019 it has continuously collapsed, and today the share trade below their price 10 years ago. Trailing valuation multiples over the last decade are below.

Foreign investors accumulated a large position in PAKT starting in 2013, pushing the P/E multiple above 72x trailing. Today at the 540 PKR/share block price the valuation is 5.6x trailing and should be ~5.1x 2023 PE. PAKT has also built up a 100 million USD net cash position as a buffer given the recent economic turmoil in Pakistan. This buffer should reach 200 million USD by year-end 2023. The block price thus represents 1.9x EV/EBITDA for 2023—the lowest in all of PAKT’s trading history, as well as lower than any other tobacco stock in the world currently.

The overall median multiple for tobacco stocks is 11.6x trailing PE and 7.7x EV/EBITDA.

EM tobacco companies actually trade at a premium to DM tobacco companies because DM tobacco volumes are declining as people quit smoking, but they remain generally stable in EMs, which are much earlier in the cycle. Also, many EM countries have large informal-sector, non-tax-paying cigarette markets. This means that as tax authorities crack down over time, branded manufacturers can gain volumes even if the overall tobacco market remains stable. PAKT’s volumes increased ~5% over the last 10 years whereas Altria’s volumes are down 36%.

Dividend Yield

The interesting aspect of PAKT’s 5.1x 2023 PE is that tobacco companies tend to have high dividend payout ratios given their low capital intensity. PAKT’s payout ratio should be ~100% in the coming years given its sizeable net cash position. PAKT’s low valuation means we should get a growing dividend yield of around 19% per annum, which far exceeds the dividend yield on DM tobacco stocks like Altria at 8%. ITC in India has a 28x PE and a 2.8% yield. Due to the low valuation purchase price, the dividend yield is so much higher on PAKT than other tobacco stocks that it should provide a substantial tailwind for a strong return on investment. Even if PAKT’s valuation discount to global peers never closes, the low purchase price provides sustained 10%+ per annum incremental return over peers. Valuation discounts matter more in a sector like tobacco, with its high dividend payout ratios, than in a sector where a large discount doubles your dividend yield, but this merely takes it from 1% to 2%.  In tobacco, the “what if the discount never closes?” argument holds little weight.

Conclusion

We will have a 19% per annum dividend yield. Additionally, earnings should grow over the coming years, potentially massively, as explained via benchmarking against tobacco companies in wealthier EMs, like ITC in India and CTC in Sri Lanka. We may get multiple expansion as our purchase valuation is lowest in PAKT’s history and below all peers. Overall we think it is fairly easy to imagine multi-bagger potential here.

A Note on Pakistan

Many of you may have little to no familiarity with Pakistan. In terms of politics, Pakistan does have elections, with multiple candidates offering different visions. There are real votes and uncertain outcomes. However, the country is far from a perfect democracy. The military has ultimate control and exerts this in various ways. We do not believe any political candidate would be viable in Pakistan if acting in opposition to core military interests.

Bear in mind that many places like Dubai and the U.A.E. have essentially no elements of democracy, yet are considered attractive investment destinations.

We believe that Pakistan is viable as an investment destination, despite its complicated political structure, because confiscations and random asset seizures are not a feature of the environment. We have followed the stock market there for a decade and have not seen this happen, or businesses worrying about it. Pakistan is making attempts to attract foreign investment and has had success over long periods. Countless global companies have invested in Pakistan from Alibaba to Nestle to Tiger Global. There would be no quicker way to scare foreign investment, than seizing a large multinational, which operates in dozens of countries around the world without issue.

Moreover, note that for tobacco specifically, the government already ‘owns’ nearly all of the business. Of PAKT’s gross revenue of ~1 billion USD in 2022, the government received ~650 million USD, primarily as sales tax on cigarettes, and secondarily as income tax on PAKT. From what was left PAKT had to pay operating and investment costs, and was left with just under 100 million USD in net income. The Pakistani government therefore kept an amount equal to ~7x what PAKT’s shareholders kept.

In terms of the economy, the long-term trend for Pakistan's GDP per capita has been up and to the right as previously shown. However, Pakistan is currently going through a severe economic crisis. Reserves are low and the currency has depreciated from ~110 PKR/USD at the start of 2018 to ~300 today PKR/USD. This has been a factor in the substantial decline that the Pakistani market has seen in recent years.

Catalyst

• None required (19% dividend yield)
• Earnings growth
• Pakistan economic normalization