British American Tobacco: Mixed Future Ahead
Summary
- Since the beginning of the year, British American Tobacco shares have depreciated in value by more than 12%.
- Recent earnings report shows that British American Tobacco's organic profit growth is in the single digits, while its volume sales continue to decline.
- The company’s dividend yield has been constantly declining in the last decade and its stock has a downside of 25% to 30% from the current market price.
Two weeks ago, British American Tobacco (NYSE:NYSE:BTI) reported its worldwide earnings results for the full fiscal year that ended on December 31, which were higher than the markets’ expectations thanks to the company’s purchase of American tobacco manufacturer R.J. Reynolds. At first, investors might have felt excited about those results, as the company saw its profit increase by 39% Y/Y. However, if we dig deeper, we will see that most of the profit came from the acquisition of Reynolds, as British American Tobacco's organic profits were up only 3.7% Y/Y, primarily thanks to the weak sterling.
Also, organic volume sales were down 2.6% on an annual basis and the tobacco industry continues to feel the pressure from the regulators that plan to enact stricter rules regarding the usage of the tobacco-based products, which are already on a decline.
In addition, if we look at other market participants from the tobacco industry, we will see that their earnings results weren’t as good as the market expected them to be. For example, Altria (NYSE:MO), which is headquartered in Virginia, announced earlier last month that its Q4 revenues were down on an annual basis, which resulted in the company’s decision to set a full-year profit guidance below market expectations.
Slow growth in the tobacco industry has been a common thing in the last few years, as the big players are starting to use their free resources to purchase new assets in order to increase the value of their overall portfolio. While the diversification might be considered a good thing for tobacco manufacturers, we are still about to find out if those acquisitions will bring great benefits for the shareholders in the long term.
Image: British American Tobacco
When we tried to find out the intrinsic value of British American Tobacco, we decided to use the traditional discounted cash flow model, which helped us to understand the full financial potential of the company. The table below shows our forecast for British American Tobacco’s major metrics for the next five years. We believe that the company’s revenue is going to be slowly growing on an annual basis, while its EBIT and EBITDA are going to be volatile from time to time due to the number of external factors that could have unexpected results in the future, such as the announcement of the new tobacco related regulations.
Source: Capital IQ, own estimates
The tax rate in our model is 21%, which is close to what the company is expected to pay in the future and the weighted average cost of capital in our analysis is 5.8%. When calculating the company’s enterprise value, our discounted terminal value has included the company’s Reynolds stake. After we made the traditional DCF calculations, our model showed that British American Tobacco stock has a downside of around 20% from its current market price.
Source: Own estimates
Note: We have updated the model last week and since that time, the stock has moved lower but still not close enough to our downside goal.
We also decided to see at which multiples British American Tobacco is being valued by the major advisory firms against its peers and created a comparable analysis table, which could be seen below. After we made all the necessary calculations, we found out that the company is trading around 50% higher from its fair value. 
Source: Capital IQ, own estimates
In the end, we consolidated the data from the DCF model and the peer to peer analysis and came to a conclusion that British American Tobacco is worth $44.31 per share, which represents a downside of around 25% to 30% from its current market price.
Source: Own estimates
While the Reynolds acquisition could be considered as a successful investment for British American Tobacco, the increase of regulations along with the decline of the tobacco consumption are going to have negative effects for the whole industry in the long term. In addition, while British American Tobacco pays dividends, its yield has been constantly declining and the current stock market started to pull back from its all-time high levels, as investors started to cash out on their investments.
Source: Google Finance, dividenddata.co.uk
While the overall picture doesn’t look good for British American Tobacco, we decided not to open a short position in the company at the moment. One of the main risks of short selling the stock, in our opinion, is the momentum the company has after it reported its earnings results and completed the purchase of R.J. Reynolds. Our strategy here is to wait for the stock to recover to its all-time high levels, where there is going to be an increased volatility and a big chance for a stronger pullback in the upcoming months.
If that happens in the foreseeable future, we will open a short position and will be waiting for the stock to decline to its intrinsic value, which will make us a great profit and decrease the dividend risk, which is aligned with the short-selling of the stock, to a minimum.
This article was written by
Analyst’s 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.
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