Approximately one month has passed since the FDA’s menthol announcement slammed British American Tobacco’s (BTI) share price and it appears to have now finally stabilized. Following this announcement I published an article outlining the reasons I’m not concerned about the FDA’s proposal. This selloff has pushed their valuation to an extremely attractive level and presents long-term investors with an excellent opportunity.
My preferred approach to valuing a company is to utilize either a discounted dividend or discounted free cash flow analysis, depending on their payout ratio. Since British American’s payout ratio is moderately high, as discussed later, I’ll be utilizing a discounted dividend analysis.
I’ll also provide three different valuation factors, with the first being the rate of return British American shares provide at their current price of $34.24. I provide this factor because there are numerous methods to calculate an investor’s required rate of return and this allows readers to simply compare their required rate of return to those offered by their shares. The second factor I’ll provide is an example required rate of return based on the capital asset pricing model, with the third being a valuation for their shares based on this model.
Since the valuation is highly dependent on British American’s future growth prospects, I’ve provided both conservative upper and lower end scenarios. The upper end scenario assumes the FDA never implements their proposed menthol ban nor regulates lower nicotine levels, their overall cigarette volume decline rate remains at a steady trajectory, they prioritize deleveraging and never meaningfully invest in any fast growing industries, such as cannabis. I feel in this scenario, assuming their future dividends grow at an annual rate of 3.97% to be a conservative assumption, which is one third the rate they grew since the year 2000. Meanwhile the lower end scenario assumes the FDA implements their menthol ban in approximately three years as well as regulating lower nicotine levels, which produces a noticeable slowdown in their earnings but not a catastrophe, as many smokers switch to non-menthol cigarettes. I feel in this scenario, assuming their future dividends grow at an annual rate of 1.9% to be a conservative assumption, which is only one tenth the rate they grew since the year 2000. Therefore, based on these growth assumptions and their trailing annual dividend of $2.54, I calculated the rates of return their shares offer as follows. When calculating their trailing dividend I converted their GBP dividend of £1.952 with a GBP/USD rate of 1.30, as discussed later this fluctuates over time.
$34.24/share @ 3.97% growth = 11.68%
$34.24/share @ 1.90% growth = 9.45%
These are quite high rates of return, especially when considering the low and conservative future dividend growth assumptions, which indicates British American’s shares are meaningfully undervalued.
To provide context and a reference point for an investor’s required rate of return, I’ll provide an example using the capital asset pricing model (CAPM). Whilst this model is far from perfect, it still provides a beneficial starting point investors can utilize to help inform their decisions. I calculated a required rate of return of 7.41% using this model with the following inputs, risk free of 2.915% (10 year U.S. Treasury), beta of 0.98 (NASDAQ:CNBC) and an expected market return of 7.5%. Since this required rate of return is below all of the rates of return I calculated above, it implies British American’s shares are undervalued, even if their future dividend growth is only a tiny 1.90%. Finally, I’ll provide the estimated intrinsic values for their shares using the required rate of return provided by the CAPM.
3.97% growth = $76.81
1.90% growth = $46.99
These results indicate British American’s shares are in fact worth between $46.94 and $76.73, depending on their future dividend growth rate, which are 37% and 124% higher than their current share price. It’s important to remember even my upper end scenario assumed a conservative future dividend growth rate and if they were to produce a higher rate their intrinsic value would increase materially. Whilst I believe this is entirely possible, I prefer basing my investment decisions on conservative estimates, thus providing a margin of safety. Since these valuations hinge on their ability to not just simply maintain but actually grow their dividend, it’s important to assess their current financial position and dividend coverage.
Finally, I’ll present an additional bonus valuation indicator to support my discounted dividend valuation analysis. The first chart I have included below shows the percentage British American’s share price has fallen from each high point over the past 24 years. Whilst there has been many 10% to 20% falls, the recent crash is the second largest and is even larger than what occurred during the darkest days of the 2008 recession. This has pushed their dividend yield above 7%, which is also the second highest during this same time period, as shown by the second chart. Even though this by itself doesn’t necessarily mean their current share price is a bargain, it further supports results from the aforementioned discounted dividend analysis.
It’s fairly common for companies to cut their dividend in order to reduce their leverage and thus British American’s financial position is an important factor to consider. Their balance sheet is currently holding an astounding £45.679b of net debt following their acquisition of Reynolds, however, this needs to be compared to their earnings before judging whether it’s manageable.
Their annualized EBITDA from the first six months of this year is $10.214b and thus their net debt to EBIDTA ratio is 4.47, which is rather high and around the absolute maximum I would normally consider as manageable. Their interest coverage of 6.66 further supports the notion their debt load is quite high, but still manageable. Whilst their debt to equity ratio of 1.28 seems quite reasonable, it should be noted that 84% of their assets are goodwill and other intangibles, which isn’t an ideal situation. Although their current ratio is a little low at 0.80, I’m not concerned as the tobacco industry has steady, smooth and quite predictable cash flows that are largely resilient to economic conditions. After combining all of these factors together it doesn’t appear they will be facing any liquidity or solvency issues in the foreseeable future. Providing they remain cash flow positive their financial position appears to be stable and manageable, however, it provides little room to cover their dividend payments should free cash flow be insufficient. I’m pleased to see lowering their leverage is one of management’s priorities, with a target of net debt to EBITDA of 3.3 to 3.5 next year, which will further strengthen their ability to continue growing their dividends.
Notes: Unless specified otherwise, all figures in this article were taken from British American’s 2018 Half Year report and all calculated figures were performed by the author.
When assessing dividend coverage I prefer to forego using earnings per share and use free cash flow, since dividends are ultimately paid from a company’s excess cash flow. Fortunately British American’s free cash flow is normally ample to cover their dividend payments and the first six months of this year were no different. They produced £3.858b of operating cash flow and after paying £716m of net interest expense, £240m of capital expenditure and £96m of distributions to non-controlling interests they were left with £2.806b of free cash flow. This easily covered their dividend payments totally £2.114b whilst still leaving spare cash to lower their net debt. Therefore, given the economic resilient nature of tobacco products, I see no reason to believe they cannot maintain and continue steadily growing their dividend.
The first and most obvious risk comes from Brexit, it’s now only months away and the path forward still seems as clouded as ever, one moment it appears they have a deal and the next minute their governing party is found in contempt of Parliament. Although I cannot tell with any certainty how this saga will finally end, I can still assess whether it’s a significant risk to British American’s operations and earnings. Whilst on the surface it appears reasonable to assume they’ll be negatively impacted from a poorly handled Brexit, I don’t believe this will actually be the case since their operations span the globe and their earnings are concentrated outside of Britain.
Earlier when detailing my valuation I briefly alluded to the risk posed by the GBP/USD exchange rate fluctuating over time. When foreign investors receive their dividend they must be converted to USD since their dividends are declared in GBP and naturally if the GBP depreciates versus the USD, their foreign investors receive lower dividends. Although this can be disappointing, it’s only a short term problem as continued weakness actually increases their GBP earnings and thus overtime they would also increase their dividend if the GBP didn’t recover. When performing my valuation I assumed a GBP/USD of 1.30, which is towards the lower end of their recent trading history and appears to be a reasonable middle ground between upper and lower end scenarios.
The final consideration is certainly the most important and stems from the possibility the people of Britain elect a Labour government during the next election. Currently these elections aren’t technically expected until 2022, however, given the current political turmoil the country may be heading to the polls much sooner. The Labour government is currently headed by Jeremy Corbyn who has unfortunately taken the party quite far left, even proposing the nationalization of various utilities as well as corporate profit sharing arrangements and tax hikes. Ultimately only time will tell whether he ever becomes Prime Minster and the extent to which he enacts these destructive policies. Thankfully due to their international diversification, British American Tobacco appears well positioned to ride out what would undoubtedly be one of Britain’s roughest non-war periods.
Following the recent selloff, British American’s shares are so significantly undervalued that even sub 2% annual future dividend growth produces an estimated intrinsic value with a 37% potential upside. Since this scenario seems quite bearish, I believe it’s likely they will far exceed this and hence their potential upside could exceed 100%. Therefore, I consider British American shares to be an excellent opportunity for long-term investors to produce market leading returns.
Disclosure: I am/we are long BTI. 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.