British American Tobacco: The Worst May Have Already Been Priced In (NYSE:BTI)

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With the latest information available after British American Tobacco (NYSE:BTI) published its annual report on February 8th, 2024, we learn that its operations remain as robust as ever, and there is a demand for alternative products, as reflected on their YoY sales growth and positive returns from this business segment. This implies that the tobacco industry might not go as soon as the market is expecting. Instead, it is evolving with the diversification to reduced-risk products. The stock jumped ~7% a day after publishing its annual results due to unforeseen profitability in its alternative products segment. They remain a resilient business with operating cash flow generation of ~100% despite continuous macro headwinds in 2023.

Management also seems to be heading in the right direction by recognizing its premium cigarette brands as assets with limited lives of no more than 30 years, showing their commitment to further invest in their alternative products business and becoming less reliant on cigarettes as their major income source. However, their recent $31.5 billion premium brands impairment does not serve as a potential tax-deductible through deferred tax asset recognition, which can benefit shareholders in the shorter run. Due to these aforementioned factors coupled with a dividend yield that is among the highest within the sector, I recommend a buy rating on the stock at its current valuation with a target of $36 per share before reconsidering its rating.

This article will discuss the potentials surrounding one of the value stocks that, I believe, offers a lucrative opportunity with potential double-digit total annual returns and limited downside. It will first start with a summary section, followed by an introduction and tobacco industry outlook, recent company performance and drivers into the future, arguments on why the company offers a significant margin of safety based on DCF valuation, risks involved in investing in the stock, and finally closed with a closing summary.

Is This Tobacco Company Still Good For One Last Puff?

Ben Graham, in his book The Intelligent Investor, signified the importance of the margin of safety relative to its fair value when buying a stock at a given price. He pioneered a way of investing in stocks that have been beaten down remarkably by the market and are trading well below net liquidation value in a strategy that is now well-known as cigar butt investing. Despite not being exactly a net-net company, as Ben Graham used to call it, the depressed price levels of British American Tobacco present a compelling investment opportunity for investors seeking high-yield income and potential capital appreciation. The industry is currently confronted with challenging regulations on all fronts, leading to the perception of a steeply dying industry. This perception, however, was shifted towards a more positive outlook coming into 2024 as presented by their positive earnings from alternative products business which is 2 years earlier than expected.

In FY2023, BATS faced many drawbacks, particularly with the most recent write-off of $31.5 billion in cigarette brands due to their expectation of being completely out of the combustibles business in the US by the next 30 years. The increasing incentives to shift away from cigarettes are attributable to soaring public awareness about the dangers of smoking and its addictive nature through socialization programs. Regulations in the country have become more hostile towards the destructive nature of tobacco products, resulting in higher taxes imposed and the ban on menthol cigarettes in California. All this bad news released throughout the past years put outstanding pressure on the company’s stock price, resulting in an approximately 20% decline in TTM price while the SP500 rallied by more than 20% over the last year. Not to mention, decreasing volume shares in combustibles sales in the US are also expected to squeeze margins should customers not be willing to pay more for the same product.

Despite the recent adverse headlines and seemingly despairing future for the company, their performance remains strong and solidified with solid cash flow generation for shareholders. The addictive nature of their products makes it more difficult for customers to quit, prompting an own-price elasticity, according to research on tobacco products. This indicates that customers are still willing to pay for higher-priced cigarettes, which leads to relatively steady revenue with operations that remain top in the industry. Propositions of legal policies, such as a nationwide ban on menthol cigarettes, have also been put on hold with the shift in political priorities coming into an election year. An overly restrictive stance on tobacco sales and lack of control on illicit vapour sales may lead to the development of an underground market for tobacco and reduced market share on vapor products, as management suggested in their FY23 announcement. Considering how the index has been particularly overweight on the tech sector during last year’s rally alongside economic uncertainty this year, I don’t see why some money would not divert away into high-yielding dividend stocks considered more defensive when accounting for expected rate cuts.

Combustibles Falling Out of Favour, but Operations Remain Solid as Ever

Adhering to BATS recent FY2023 announcement, an undergoing transition for BATS is apparent by looking at the sales growth of their alternative products. Despite the struggling sales of traditional products, they were able to grow the revenue generated from new categories by a significant amount on a constant currency basis. If we look at the revenue breakdown on a constant currency basis, it can be seen that their revenue grew by 1.6% over FY2023. The decrease in volume in their cigarette brands consumption is also largely offset by the increase in pricing, as reflected by seemingly stable revenue from this sector on a YoY basis while keeping currency constant. Assuming that the current trend remains for years to come and neglecting the change in USD/GBP currency, I can see the company continue growing its organic revenue in the 3-5% according to management guidance.

Since the tobacco businesses had become targeted by regulators due to public health concerns, the additional costs and regulations imposed on these products have translated well into their revenue growth. The decline in their US combustible sales alone can seem alarming for investors. Fortunately, their robust global footprint enabled them to at least maintain their current level of firm-wide combustibles’ revenue. As management continues to deliver with their strategic execution and growth in sales in other regions, I am confident that they are capable of maintaining the current level of revenue from combustible products in the coming years. The trend for improving their overall combustibles sales outside of the US region is also supported by the projections of a 2.54% CAGR in total revenue from tobacco products, with cigarette sales growing according to Statista, during 2024-2028.

The Worst May Already Have Been Priced-In For The Stock With High Dividend Yield

Looking at the chart generated in Seeking Alpha over the past ten years with accompanying metrics such as P/E, P/CF, net income margin, EBIT margin, and FCF margin, their profitability remains as robust as ever despite tumbling share price. Valuations can be considered attractive relative to their historical valuations. BTI remains a healthy company that can still return >$8,000 billion in levered free cash flow to shareholders with ~24% levered FCF margin. Their adjusted operating margin and cash from operations conversion of 45.5% (+60 bps YoY) and ~100% respectively remain among the top compared to other players in the industry, trailing only Altria Group. Their valuation attractiveness is further reinforced by their P/E and P/CF ratios of 6.07 and 4.97, significantly below their 5-year means and among the lowest compared to their competitors.

A discounted cash flow analysis that I did further implied a fair value of about $35.87, using a scenario that, in my opinion, has already reflected the worst possible scenario for the stock. The analysis uses the assumptions as shown in Figure 4. It uses an EV/EBITDA exit multiple of about 6 and a very conservative -2% perpetuity growth assumptions, effectively assuming that the company would lose substantial revenue generation power after a strong track record of producing cash flow. This 6 EV/EBITDA multiple is acquired after comparing BTI to its peer and considering the lower end of their EV/EBITDA FWD multiple. I used the analysts’ revenue estimates until 2028 to prognosticate the FCF returned to shareholders. The revenue estimates are then adjusted to 2% less than the analysts’ consensus on a YoY basis, providing a more conservative guidance for their earnings. The cash flow estimates are then calculated using the net income deduced from the average net income margin and the lower end of revenue guidance, added with D&A less capex less increment change in NWC. The free cash flows generated from this calculation are slightly lower than the reported unlevered free cash flow, in line to provide a more conservative view of the business performance. The firm-wide cost of debt is obtained through their FY2023 announcement, corresponding to higher interest rates in the market. The rest of the figures are then obtained using Seeking Alpha calculations on the stock.

By using the assumptions on Figure 4 combined with WACC calculation using the CAPM model, I could find an implicit enterprise value of $124.169 billion. After subtracting debt and adding cash and marketable securities, I deduced an implicit equity value of about $80 billion, implying a $35.87 fair price per share. At the time I made the model, the price of BTI was somewhere around $30.5, indicating a potential 18% undervaluation at the current price using a somewhat conservative measure. It can be seen that the stock might have already priced in the worst-case scenario that could happen to the business. Considering the recent optimistic announcement of their alternative products business becoming profitable 2 years ahead of target and global settlement with PMI over HP and Vapour products, we should even see up revisions on their earnings projections in years to come.

Apart from the implied undervaluation, the dividend offered by BTI to its shareholders is undeniably one of the highest in its sector for now. With a trailing dividend yield of 9.5%, while being well-covered by its earnings as reflected on its TTM cash dividend payout ratio of 49.87%, it offers one of the most lucrative opportunities for income-seeking investors. Although their dividend payments have only been growing by about 2.3% CAGR from 2019 until 2023, their currently depressed price level makes the yield too attractive to ignore. Their 5-year average cash dividend payout ratio has also been around 50% which is still slightly below the sector median of 53% and roughly equivalent to their TTM ratio. However, it can be seen from Figure 6 that they are only able to maintain a D grade on their dividend safety based on the Seeking Alpha quant system. This grade, however, seems to be exacerbated by the impairment cost that they recognized through FY2023 that resulted in a GAAP net negative income. This negative net income implied a -2.82% dividend coverage ratio and an F rating compared to the sector median. Investors should not worry too much about their dividend safety concerning the amount of cash that they can produce and dividend payment relative to net income without big impairment charges as what happened this year.

Risks

Investors who decide to invest in a company operating in the tobacco industry are presented with risks regarding macroeconomic conditions and shifting consumer preferences. Regulations imposed on the distribution of tobacco products remain an ongoing issue for these businesses, with the restrictions on the variety of products that they can sell. Moreover, the potential ban on menthol cigarettes and lack of control over illicit vapor products continue to serve as challenges that might disrupt their operations in the US for years to come. The uncertainties tied to the industry present risks to the operations of their business should they materialize sooner than expected. Operations spanning multiple countries and the nature of their operations also present risks from geopolitical tensions arising from different areas in which they operate and potential litigations. Risks coming from these areas are, however, more difficult to measure as they are much harder to predict reliably. Foreign exchange risks also continue to be an inherent risk as reflected in their losses from GBP/USD rates, although their revenue grew by about 1% on a constant currency basis.

Closing Statement

In summary, I would like to iterate a “buy rating” for BTI on my first-ever coverage of this stock. While there are inherent risks for holding on to the stock, such as macro headwinds, the current overly pessimistic valuation seems to provide a considerable margin of safety. Toppled with a high dividend yield that compliments the discounted price, I think BTI provides an attractive risk/reward profile for investors willing to hold for a medium to long-term horizon and collect dividend payments on the sidelines while waiting for its value to be unlocked. As long as the management keeps delivering on their guidance, there might be some unforeseen growth due to a faster-than-expected shift to sales of alternative products and increased market value in other regions.

Thank you very much for your time in reading this article. I would love to hear your opinions regarding this article in the comments section, and I will try to address them. Please consider this article as a stepping stone in your due diligence and consider the risks associated with the stock before making an investment decision.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.