Obviously, my previous purchase of British American Tobacco (BTI) in January of 2020 currently stands at negative returns – though this is only part of my rather respectable, 0.8%-weighting British American Tobacco stake. The pandemic threw everything into chaos, and this included the tobacco giants, all 3 of which – Philip Morris International (PM), Altria (MO), and British American Tobacco – I own.
However, what’s important here are the underlying fundamentals and the valuation we’re seeing for the company, as well as how the safeties during and after the pandemic are looking.
And as far as those things go, things aren’t just looking good, they’re looking pretty great for this tobacco giant.
British American Tobacco – How has the company been doing?
In my latest article, I showed you a quick overview of the company as well as its businesses, safeties, and everything related to it which I viewed to be relevant to investment consideration. The company that owns Lucky Strike needs little introduction, but it’s sometimes healthy to just go back and see exactly how a company’s portfolio looks.
Like other large tobacco companies, BTI walks the tightrope between appealing to vaping/smokeless product users and traditional users of combustible tobacco products such as cigarettes and related products. And like its two peers, the company does this remarkably well if we look at overall company performance.
Reporting-wise, we have a very recent market update as of the period commencing during 1st of July 2020. As of this time, BTI sees:
- Continued volume growth across the combustible business, indicating a development opposed to overall expectations (where combustible consumable products would be expected to decline).
- Continued growth in the three new categories of sales, vapour tobacco heating and modern oral products.
- Excellent results in developed markets, with strong pricing and very little downtrending acceleration. The business performed particularly well in the US segment, which BTI considers extremely resilient in the face of COVID-19.
- Negative impacts and flow can be seen more in markets like Asia (Bangladesh, Vietnam, Malaysia), and closing measures in South Africa, Mexico and Argentina have persisted longer than BTI expected, affecting overall sales. In South Africa, there is a COVID-19 tobacco sales ban which currently shows no sign of being lifted.
The company has announced an impact on international travel retail sales, which means that the current FY guidance as of essentially 1H20 is expected to be around 3% on a constant currency basis. Because of this, the company now “only” expects a constant current adjusted Rev. growth of 1-3%. I consider this still to be very positive all things considered.
BTI’s focus is increasing on its new categories business, with share growth (as mentioned) across all categories. The company has recently launched products in THP, and while COVID-19 has disrupted expected growth and led to some scaling back and postponements of launches, things in these categories are going well, and BTI is expected to grow more into these categories with its £5B target for 2025.
Given these headwinds yet continued expected industry development, BTI guides for:
- Mid-single figure FX-adjusted EPS growth (down from high single figure).
- Continued deleveraging with the goal of 3X adj. net debt to adjusted EBITDA by FY21 (previously below 3X).
- Continued dividend payout of 65% of adj. diluted EPS, keeping dividends stable.
The company expects continued growth in cigarettes, strong US growth, good operating margins, and strong cash flow conversions above 90% of adj. profits from operations – all more or less as expected before, with the added problems of COVID-19 lockdowns in key markets.
(Source: CNC markets)
So – BTI has done well overall, with volume and sales growth, yet some issues persist and have been added to by the coming and persisting effects of COVID-19. The market-changing trends in tobacco haven’t materialized in key markets (such as the US), and there are no signs that such trends would materialize in markets that are as yet shut down, once they open back up.
During the depths of COVID-19 (here in Europe/Sweden, the USA can still be said to be in the depths of the COVID-19 crisis, while as of writing this article, numbers and deaths are down to single digits in Sweden, at least), there was an extensive argument against tobacco as a whole and a somewhat illusory expectation that the crisis would cause an en masse exodus from the usage of tobacco.
There is no evidence or indication as of yet that this is the case.
With that said, let’s move onto valuation.
British American Tobacco – What’s the valuation?
Things are continually looking good here in terms of company valuation. Take a look at what’s happened to the company as of late.
(Source: F.A.S.T Graphs)
The valuation has become completely disconnected from the earnings trends and growth expectations. Yes, we won’t be seeing 20-30% earnings growth trends like we did 10+ years ago, which drove the company to at times trade at a premium. However, the company dropped essentially at a time when they came out of an earnings slump, growing EPS by 28% back in 2017. For some reason, the market believes that BTI simply won’t be succeeding all that much going forward. Trends and forecasts at this time do not support this conclusion, marking the company as an undervalued investment.
(Source: F.A.S.T graphs)
Even trading perfectly sideways in terms of valuation, and expecting only the sort of single-digit EPS growth the company forecasts, your returns investing today would be in double digits. If we start to expect the company moving back towards normal valuation multiples, returns start to move into the 15-20% annual range, with a return to “fair” value generating a 25% annual rate of return based on current earnings forecasts.
Analysts aren’t historically poor at forecasting BTI, having an 82% accuracy ratio on a 1-year basis with a 10% margin of error, and over the past 10 years, they’ve never been off more than 14% back in 2014. This is a pretty good track record, and a pretty good return potential, looking at this company.
So, what is the reason I’m not endorsing or often buying more BTI as opposed to some of the other companies I often write about? Well, BTI does come with some caveats which need to be considered, beyond the simple fact that it’s a tobacco company. These are considerations I make according to my system, which I’ve come to call QO-system (standing for Quality/Opportunity).
First, and perhaps most damning, there’s the fact that BTI shares an almost Swedish-like lack of care for its dividend record. The current interrupted dividend streak for BTI is a whole, whopping 2 years. This immediately disqualifies it as any sort of reliable stock in terms of DG investment, and pushes it down to class 4, regardless of its BBB+ credit rating, relatively acceptable payout ratio and high yield. The dividend safety is paramount when it comes to my rating a stock in the QO-system, and the low dividend streak also means BTI sports a “Borderline” dividend safety with a fairly low dividend growth, all things considered.
This pushes BTI – different than Altria and Philip Morris – into what I would consider more speculative territory. Not because the segment is speculative or because I believe the company may face trouble – there’s simply very little saying how the company will perform for shareholders in the long term, or when it decides to once again cut the dividend in accordance with its policy.
Otherwise and other than that, BTI is actually quite an excellent stock and seems to be an excellent investment. The problem here is relational – relational in the sense that you can buy 6.56%-yielding Philip Morris, with a better credit rating, dividend streak, and management considered “Exemplary” by Morningstar. In my system, this simply makes Philip Morris, a class 2 stock, the better choice. Even class-3 stock Altria, with its 50-year dividend streak (class 3 due to payout ratio and considered dividend safety at “borderline”) and a yield of 8.53% is better compared to this tobacco company at this time if I go by my way of judging stocks.
In a world by itself, BTI is a “BUY” and a qualitative stock, even if it’s marred by dividend safety issues. Its products aren’t going anywhere, and I own a sizeable 0.5% stake in BTI in my portfolio.
However, I didn’t invest in BTI until my stakes in Altria and Philip Morris were at a size where I considered them “filled”. That’s the real rub here, and it brings me to my thesis.
If you’re at a maximized exposure to companies like Altria and Philip Morris, yet feel as though you want more tobacco, then BTI becomes an excellent potential choice for you at a superb yield. Despite lacking the same sort of dividend safety, this company will no doubt (in my mind) succeed in the long term, and the fundamental risks to the company are ones I considered comparatively “small”. Because of this, BTI becomes a “BUY” – and that’s also the stance of this article. There is a 26% upside to the stock at a conservative target, as I see it.
However, if you take a look at your portfolio and see that Altria and Philip Morris aren’t either in it, or at a lacking size, then I would consider you look at these companies before looking at British American Tobacco. From a dividend safety, quality, and fundamental perspective, I see very little reason to pick BTI over these two – this is also how I’ve invested in Tobacco.
Let me know if you agree or disagree, and how you’ve invested (if at all) in the sector – and send me any questions or comments you may have here.
Thank you for reading.
British American Tobacco is a “BUY” with a 26% potential upside at an excellent yield with acceptable safeties, even if other tobacco companies should be considered first.
Disclosure: I am/we are long BTI, MO, PM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.
I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.