British American's Investment Considerations
• The oligopolistic tobacco industry is attractive in a number of ways. Firms sell an "addictive" product (cigarettes and/or smokeless tobacco), have significant pricing power, generate high margins, and strong returns on invested capital. Declining trends in smoking in the US, threats of tobacco-related litigation, new tobacco regulation (labeling) that discourages tobacco use, and excise tax price shocks that may impact demand will always be concerns. In any case, we tend to like the structural characteristics of the tobacco industry and the shareholder-friendly policies of constituents.
• British American Tobacco (NYSEMKT:BTI) manufactures and sells tobacco products. It produces cigarettes, roll-your-own tobacco, cigars, and snus, as well as other nicotine products and electronic cigarettes. The firm offers its products under many brands, including its core 'Global Drive Brands' Lucky Strike, Pall Mall, Dunhill, and Kent. It is based in London, England, and its products are available across the globe.
• Currency headwinds have been putting significant pressure on British American's top line recently. Volumes have also been down, but the firm boasts material pricing power, helping buoy its bottom line. We don't think raising the "smoking age" to 21 will have much of an impact on British American Tobacco's business, even if it spreads beyond the state of California.
• Contingent legal liabilities will always be a concern for cigarette makers. Many have claimed or expressed concerns that mentholated cigarettes pose greater health risks than non-mentholated cigarettes. British American has a 42% stake in Reynolds American (NYSE:RAI), which recently merged with Lorillard, increasing its exposure to legal risks.
• British American Tobacco has done wonders in recent years in terms of its operating margin improvement. From 2010-2014 the firm expanded its operating margin by 550 basis points, vastly outperforming many of its peers across the globe over that period. Management noted that in 2015, "without the adverse transactional impact of foreign exchange, operating margin would have improved by around 160 basis points." Meanwhile, its capex focus has been shifted to growth and innovation initiatives.
• British American Tobacco's 'Global Drive Brands' are expected to continue to drive growth through pricing power, increased marketing investment, and geographic expansion of the next generation products.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. British American' 3-year historical return on invested capital (without goodwill) is 28.7%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. British American' free cash flow margin has averaged about 24.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At British American, cash flow from operations decreased about 19% from levels registered two years ago, while capital expenditures fell about 20% over the same time period.
In 2015, British American reported operating cash flow of ~£4.7 billion and capital expenditures of ~£480 million, resulting in free cash flow of ~£4.2 billion, a ~33% increase from 2014.
This is the most important section of our analysis, and all of the previous sections have been building to this. Below, we outline our valuation assumptions and derive our fair value estimate for shares.
Our discounted cash flow model indicates that British American's ADRs are worth between $80-$120 each. Shares are currently trading at ~$117 per share, in the upper half of our fair value range. This indicates we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $100 per ADR represents a price-to-earnings (P/E) ratio of about 19 times last year's earnings and an implied EV/EBITDA multiple of about 14.8 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of -1.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -3.2%. Our model reflects a 5-year projected average operating margin of 45.5%, which is above British American's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years and 3% in perpetuity. For British American, we use a 9.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $100 per ADR, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for British American. We think the firm is attractive below $80 per ADR (the green line), but quite expensive above $120 per ADR (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate British American' fair value at this point in time to be about $100 per ADR. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of British American's expected equity value per ADR over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's ADRs three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $123 per ADR in Year 3 represents our existing fair value per ADR of $100 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
British American will always be concerned with contingent legal liabilities, and its 42% stake in Reynolds American increases its exposure to such legal risks. Shares may feel pressure as more and more states like California push to raise the smoking age to 21, but the firm has a global footprint that mitigates this risk. Though currency headwinds and volume pressures will continue to present challenges, the company's pricing power is expected to counteract the obstacles in a material way.
British American Tobacco has worked wonders in recent years as it relates to its operating margin improvement. From 2010-2014 the firm expanded the operating margin by 550 basis points, vastly outperforming many of its peers across the globe over that period. Meanwhile, its capex focus has been shifted to growth and innovation initiatives. We are fans of British American's resilience and especially its product pricing power! The firm currently registers a 4 on the Valuentum Buying Index. We're watching shares closely.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.