Why British American Tobacco’s Big Shift Is So Important for High-Yield Investors

British American Tobacco (BTI 0.03%) owns the Camel, Newport, Lucky Strike, and Pall Mall cigarette brands. Although it is a U.S. cigarette maker, it has a global footprint, which separates it from both Altria (MO -0.89%), which only operates in the U.S., and Philip Morris International (PM 0.09%), which sells cigarettes internationally but not in the U.S. market.

British American Tobacco made a huge admission about the future of the U.S. cigarette market in 2023 that investors in tobacco stocks should not ignore. Here’s what you need to know.

British American Tobacco changed its accounting

Although a somewhat complex topic, the issue here boils down to the accounting treatment of British American Tobacco’s U.S. cigarette brands. Previously the company assumed that the brands would be around forever — but now it has decided that, at some point, they will no longer exist. The company described the change as:

…with effect from 1 January 2024, Newport, Camel, Natural American Spirit and Pall Mall will be amortised on a straight-lined basis. Pall Mall will be amortised over a 20-year period and Newport, Camel and Natural American Spirit will be amortised over a 30-year period. From 2024, the increase in annual amortisation expense is expected to be £1.4 billion per annum for the next 20 years, after which it is expected to decline to £1.3 billion.

In plain English, British American Tobacco is basically saying that its best guess is that Pall Mall as a brand will have little to no value in the U.S. in 20 years. Newport, Camel, and Natural American Spirit will likely end up in the same place just 10 years later. This is a big change, and it means that the company has to amortize the value of the four brands each year, which is basically taking a charge that accounts for the loss of their value during that year. That extra cost will be a headwind to earnings each year. This is going to have a material lingering effect on the company’s financial results.

But that’s not all. British American Tobacco’s decision also forced it to immediately reduce the carrying value of the brands on its balance sheet:

In addition, the Group have recognised a non-cash adjusting impairment charge of £23.0 billion against certain of our acquired U.S. brands which have been previously recognised as indefinite-lived and an impairment to the Reynolds goodwill of £4.3 billion…

The end is nigh for U.S. tobacco

The big-picture takeaway here is that British American Tobacco is effectively telling investors that the U.S. cigarette market is not just in a steady decline, but that it will eventually go to zero. That clearly impacted the company’s 2023 results, which fell deep into negative territory thanks to the write off. To put a number on that, earnings declined 322% year over year in 2023. However, it is important to note that a smaller headwind will continue each and every year for the next 30 years thanks to the increase in amortization costs.

And then investors need to consider the broader statement being made. British American Tobacco has a global portfolio of cigarette brands, with some markets performing differently than others. So there’s an offset of sorts to its U.S. business.

But what about Altria? Altria and Philip Morris International effectively share the Philip Morris portfolio of brands, headlined by Marlboro. Philip Morris International sells the brands internationally, while Altria sells them only in the U.S. market.

British American Tobacco’s accounting shift basically suggests that Altria’s cigarette business has an expiration date. Philip Morris International is in a better position because, like British American Tobacco, it operates in foreign markets.

The big picture isn’t great for tobacco makers

The U.S. is probably ahead of the curve, to some extent, when it comes to cigarette demand trends, so investors need to pay close attention to the decision British American Tobacco just made. It might be off on the exact dates, but it is telling investors to expect that cigarettes will eventually be phased out.

And that increases the need for British American Tobacco, Altria, and Philip Morris International to find new businesses to replace the dying cigarette lines that now dominate their income statements. If you own any of these companies, you need to start paying very close attention to the success they are having in the effort to find a replacement for cigarettes. Given its U.S. focus, dealing with this decline is probably most important for Altria.