British American Tobacco: The Dividend Yield Is Very Tempting At These Price Levels

Introduction

British American Tobacco (NYSE:BTI) caught my attention due to its especially high dividend yield, so I wanted to take a look at the company’s financials and give some opinion on why the shares might be trading at such depressed levels, and why it may continue for a while longer. The high debt levels may deter many investors, but a double-digit yield seems to be rather safe and will attract many investors who are seeking juicy yields. Even with what I consider conservative estimates, the company seems to be trading at a decent price, so people can lock in this dividend yield, be patient, and hope for operational recovery while the company continues its transition.

Financials

As of FY23, which ended 31^st Dec ’23, and was published on Feb 9^th ’24, the company had around $6.7B in cash and equivalents, against a whopping $44B in long-term debt. This number will put off many investors who tend to be more debt-averse. This could also be one of the reasons that the company’s share price is underperforming. It is not the main reason but a valid reason, nonetheless. There are a few metrics I like to look at, to see if the debt outstanding is a problem. Firstly, the debt-to-assets ratio has been hovering at around 0.3 for the last 5 years, which is well below what I consider to be overleveraged. Secondly, the company’s debt-to-equity is also well below my limit of 1.5, hovering at around .60 on average and 0.74 as of FY23. Lastly, to make sure the company is able to pay down its outstanding debt obligations, I like to look at the interest coverage ratio. Here, analysts consider a 2x ratio to be healthy, so the company’s average ratio of around 7x is more than sufficient. The company passes all three metrics with flying colors, so it is safe to say BTI is at no risk of insolvency. Do note that the goodwill impairment charges, were non-cash items, so FY23’s ratio is not accurate.

In terms of revenue, the company has been stagnating for quite a while, which is not a surprise, given the shifts in consumer behavior. I honestly would have expected steeper declines since people are smoking less, but the company getting into the smokeless alternatives kept its top line quite robust.

The company’s margins have been very consistent over the years, and if we take out the non-cash charge in the latest year, there is no impact on the company’s profitability and efficiency.

The same story unfolds with the company’s ROA and ROE, if we take out the non-cash charge, these have been relatively stable, and I don’t think are going to get any worse. All in all, the company seems to be running quite efficiently.

In terms of competitive advantage against its peers, BTI’s return on total capital or ROTC has been on the lower end, and much lower than its closest competitor Altria (MO). It seems that Altria may have the upper hand here.

The company’s cash flow is at all-time highs, so the company is a cash cow, it just needs to put that cash to good use, to entice investors in starting a position.

Overall, it looks like the company is just cruising along very consistently, which is better than seeing a negative trend in all of the metrics above (if we ignore the non-cash charge). Little to no growth is not bad, but it is also not very exciting for people who are looking to grow their capital. This type of performance overall can justify the company trading at such a low P/E ratio. If there isn’t much growth left in the company, I would like to see profitability and efficiency improving, however, margins are quite decent already, so I am not sure how the company could improve there. As long as the company can maintain such high cash flows, it can repay its outstanding debt, continue paying that juicy dividend, and look for ways of growing the company and rejuvenating top-line growth, or at least not let it start declining. All strategies should attract shareholders.

Comments on the Outlook

The general consensus among tobacco companies is that the declining cigarette use will erode their top line, hence most are trading under a P/E ratio of 10. The use of tobacco has been on a decline for a while now, especially in developed markets, coupled with anti-smoking marketing driving uncertainty that BTI will transition to a smokeless alternative product manufacturer and maintain its revenues. The so-called “sin stocks” have become much less popular among the younger generations, who may be more ESG-oriented and tend to avoid gambling or tobacco companies.

Speaking of transition, some categories are growing much better than others, with Vapor being the outstanding one. The new categories of alternatives to cigarettes are still quite small (around 12% of total revenues), so the transition will take a long while, and we won’t know how successful this transition will be. Still, I commend these companies for trying to stay in the business and not extinguish with the last cigarette. This is one of the reasons the company is trading at such multiples. The uncertainty of the transition. Altria is a strong competitor that has been focusing on alternatives for a while now, and its products are very popular. I am worried that BTI won’t be able to capture a decent market share if they fall behind the formidable competition.

Speaking of alternatives, the long-term health effects are not yet known, since there isn’t a lot of data gathered so far. We have all the data we could want on cigarettes and how bad they are for a person’s health. Cannot say the same about these alternatives. They may be better than smoking cigarettes, but there is still a lot of uncertainty on the long-term effects they may have. At first glance, it looks like they are much healthier than smoking, but with the research done by the cigarette companies themselves, I tend to be a bit more skeptical.

With time, the more people transition to smokeless alternatives, the more we are going to see some sort of health problems pop up from the usage of said alternatives, which leads me to another important factor that may be weighing on the company’s share price, lawsuits.

Many investors tend to avoid these companies since they are always involved in class-action lawsuits, blaming second-hand smoke for affecting their health, and getting lung cancers, heart disease, and other respiratory illnesses. To settle these lawsuits, companies like BTI have to cough up mountains of cash to cover all the legal fees and damages. Investors don’t like to get involved with such companies, for moral reasons or otherwise. I wouldn’t be surprised to see some lawsuits popping up regarding the smokeless alternatives, once the effects set in after prolonged use.

So, in short, declining cigarette revenue will continue to weigh on the company’s performance, especially if it cannot substitute it with the alternatives fast enough. Negative health effects will certainly bring in lawsuits, and the company needs to have enough resources to cover all the fees and settlements. Regulations may also put a damper on some of these new alternatives after we know a lot more about them, and that uncertainty is most likely to keep the company’s multiples depressed, so is the company actually cheap?

Dividend

As I mentioned earlier, the company’s double-digit dividend is what prompted me to look a little deeper into the company. I would venture a guess, that a lot of BTI investors are here solely for the juicy yield and don’t really care about the company’s products and whether they are harmful or not. Most of the time, people invest to maximize returns and are unwilling to forego a couple of percentage points if that means they are investing responsibly, as this paper suggests. Maybe with the next generations getting older and entering the investment space, this will change, but we’ll have to see those studies and how it is going to turn out with time.

To be honest, I don’t blame them, as I would fall into the maximizing returns category. So, a 10% yield does seem a little unsustainable, but is it? In short, I would say yes. Just last month, the company raised its dividend by 6.1%. This is one of the comforting signs that the company feels financially strong and provides us with confidence that it won’t be cut any time soon. However, things can change, and it is not unheard of for companies to raise dividends and then the same year cut it in half or more. Pfizer (PFE) did that long ago, while Kinder Morgan (KMI) did that in 2015, right after it increased its dividends.

With such a high dividend yield, I don’t think there is a lot of room for growth going forward, so it is risky in that sense. The company’s dividend per share is $2.92 currently and in FY23 the company’s free cash flow per share was basically double that, at $5.80 a share. This suggests that a payout ratio of around 50% is more than sustainable in my opinion, so I don’t think the company is going to cut the dividend in half, which would still be a decent dividend, however, that would surely bring its share price down even further.

Valuation

Let’s look at some scenarios to see what a fair value would be to buy the company at.

For revenues, I went with basically no growth. The reason is that the declining cigarette revenue will most likely be offset by alternatives in the long run, but I don’t think those alternatives will provide any meaningful growth going forward. Analysts are in the same boat but a bit more optimistic. To account for a better outcome and even a worse outcome where the company sees declines to outpace alternative gains, I also modeled two additional scenarios. Below are those scenarios, and their respective CAGRs.

In terms of margins, as I mentioned earlier, these are already quite impressive, so to be on the safer side, I decided to keep these about the same, except for improving EBIT by around 300bps, which led to the same improvement in the bottom line too. You’ll note that my EPS is still much lower than what the analysts are estimating.

For the DCF analysis, I decided to go with a discount rate of 7% for the base case, instead of the company’s WACC of 4.7% because I would like to have a bit more margin of safety. 4.7% seems awfully low. Additionally, I went with a 1% terminal growth rate instead of 2.5% as I usually like to use because I don’t think the company could grow at those numbers. This way, I am getting even more room for error in my estimates. To top it all off, I am going to add another 15% discount to the final calculation, just to keep it extra safe. With that said, BTI’s intrinsic value is around $30 a share, meaning it is trading close to its conservative fair value.

Risks

The main risks will involve the company’s transition away from the bad habits of smoking to the less risky perceived alternatives and whether people are willing to invest in “sin stocks”. As I mentioned, a lot of them don’t mind as long as they are getting good returns.

The alternatives segment may not perform well and may not successfully replace the lost revenues of cigarettes, bringing the share price further down.

Cash flow in turn worsens, and the company is forced to cut the dividend, or completely axe it. Many investors will flee if that happens, and the share price will continue its tumble.

The debt becomes harder to pay down if cash flow comes significantly down, which will further detract investors from holding the company in their portfolio.

Future regulations that are not in effect yet due to the relatively small data on alternatives to people’s health may ban certain products, just as we are seeing with menthol cigarettes and flavored vapes.

Closing Comments

So, on paper, it does look like the company is trading at its fair value, but my assumptions were quite conservative. I am assuming a Forward PE ratio of 10, while many analysts are putting a Forward PE ratio of around 6 due to higher earnings numbers compared to my assumptions.

For a company like BTI, the main attractor is its dividend yield for sure, and a double-digit yield is not easy to come by, especially the one that seems to be quite safe in my opinion. So, I would say it is not a bad time to start a position here, lock in that yield, reinvest the proceeds into more shares in BTI or somewhere else, and hope that the management doesn’t decide to cut it. On the other hand, is the yield enough when the company’s share price continues to slide? That is up to the individual investor and whether they believe the company’s share price will recover in the long run, and while they wait for that to happen, they are getting paid well for their patience.

Given the conservative estimates above, I considering starting a position at these price levels, and may build it out over the next year or two, especially if the share price stagnates or drops further.