Description

Summary

British American Tobacco (BTI) has been a value trap for the past five years, trading in a tight $32-45 band since late 2018.  At 7.8x forward earnings, BTI now trades at a valuation lower than during the worst of the Great Recession, and roughly in line with its lows in March 2020.  With an 8.3% dividend yield, BTI is perhaps the cheapest quality value stock we have seen in a long time.

Apart from the valuation/yield, we like the fact that it generally is non-cyclical, will benefit from a weakening dollar and is on the cusp of improvement in earnings growth.  Inflation has had little impact on the company either.

BTI long term expects earnings growth in the mid-single digits.  With buybacks, EPS likely grows by 6-7% per year, inline with the past decade’s growth (6.7%).  Throw in the 8%+ yield, and without any re-rating whatsoever and BTI can be a 14-15% IRR stock for investors. 

However, we think that there is a good chance that BTI is nearing an inflection point in terms of growth.  In 2024/2025, growth may accelerate to perhaps the high single digits or low double digits.  As the company adds non-combustibles to their mix, margins should continue to move higher as the company scales into these products.  Non-combustibles are also taxed at lower rates than cigarettes.  As we have seen with Philip Morris International (PM), the market is more willing to pay a premium multiple for a tobacco business with a larger percentage of non-smoking products in the portfolio.

We peg the downside in BTI at $33-35 (from $36 today), and upside to $50-70 plus dividends in 1-3 years.

This is a chart of the forward P/E ratio for BTI back to 2005.  It trades in London under the BATS LN ticker, and in the US as BTI.

Business

Tobacco is a bit of a misunderstood industry.  Heavy regulation and limited ability to advertise ensures that new entrants have almost zero shot at entering the space.  Big tobacco will only get bigger.  Disruption appears less and less likely too as the winners in the e-cigarette space have already been written.  Juul market share is today well below BTI’s Vuse.  

Bears point out that tobacco names will never trade at historical P/E multiples owing to heavy government regulation and the movement toward ESG investing.  But the irony is that regulation only ensures that the supply side of the industry remains tight.  Moats are gigantic, and EBITDA margins tend to run well over 50%.  Cessation rates have been stable for years (decades in fact), and with pricing power, the tobacco industry typically offsets volume declines (in the 1-6% range depending on the country), with price increases. We estimate that BTI earns over 70% gross margins on its e-cigarette products vs 50% for cigarettes. 

While investors today seem loathe to pay a decent multiple for a volume declining consumer staple, the reality is that 1) prices are quite low in the US still (compared to other geographies) and 2) volume increases in smokeless products will eventually tilt the overall balance into lower volume decline.

On the ESG front, research indicates already that vaping and heat not burn products are dramatically safer for users than combustibles.  BTI is also a member of the Dow Jones Sustainability Index.  Some ESG backlash could also improve the odds of institutional acceptance of tobacco names. 

Capitalization

BTI levered up to purchase Reynolds in July 2017.  At closing, BTI was approximately 4x levered on a debt/EBITDA basis.  For a company worth between 7-12x, it was on the high side.  Today leverage is quite manageable at 3.2x, and the company expects that to fall to 3.0x by year end 2022 when they report. Long term their goal is 2-3x leverage, but even at 3.2x currently, the company is investment grade rated BBB+/BBB2.

The dividend is probably the number one priority for most holders of BTI.  They have grown the dividend at a 7% CAGR over the past decade, and target a 65% payout ratio of net income (where it is today).  FCF conversion tends to hover very close to 90-100%, so the risk of a cut seems quite low. 

Business

There is a prior VIC write up of BTI worth reading for some background.  The company IPO'd in 1998 after BAT Industries separated their tobacco unit, British American Tobacco.

While BTI has made many smaller acquisitions over the years, the largest was its purchase of the 57.8% stake in Reynolds American in mid-2017 for $27BB.  They paid 9.5x on an EV/EBITDA basis, which seems about 1 turn expensive given today’s multiples.

Here is their current portfolio divided by management into “Combustibles” like cigarettes, and “Non-Combustibles” which includes “New Categories” like e-cigs.