I last talked about British American Tobacco (BTI) in mid-January, discussing my investment thesis for the company. Since then, the company's stock has returned more than 15%, roughly double the overall return of the market since then. On top of that, investors at that time would have locked in dividends >8%. The purpose of this article is to update my thesis and discuss why I still believe the company is a solid long-term investment.
British American Tobacco 2018 Results
Despite a tough time for the company's stock price, British American Tobacco had a strong 2018, where it met its goals.
The company achieved strong revenue growth in its strategic portfolio of 8.5% year over year. This combined with the company improving its market share in the combustibles market by an astounding 40 bps. Overall, the company had strong results and growth across all of its business. This was in spite of significant investor worries about the viability of the company's business and long-term earnings potential.
This overall results in high single figure constant currency earnings growth for the company. The company used this to increase its already high dividend by a respectable 4%.
British American Tobacco New Product Categories - British American Tobacco Investor Presentation
A major part of the company's 2018 results was its success in new businesses. The company achieved strong revenue growth across these targets and anticipates an astounding 5 billion pounds of revenue from these sectors by 2023/2024. The company is hoping these new categories will result in steadier and stronger long-term results and revenue growth.
As can be seen, the company had strong 2018 results, despite its stock price having a difficult time. The difficult time the company's stock price faced was due to the "menthol risk". As a result of its acquisition of Reynolds American, British American Tobacco is the most exposed of the major cigarette companies to menthol cigarettes. The company derives 25% of its earnings from these cigarettes.
Menthol Cigarettes - Bloomberg
Fears over menthol cigarettes quickly impacted British American Tobacco's stock price as a result of investor fears over the company's financial health should such a ban happen. The rationale behind these fears is that if a ban happened tomorrow, for example, the company would likely be forced to cut its dividend significantly in order to preserve its financial health.
However, I feel that such a ban is incredibly unlikely to happen, and even if it doesn't, it's unlikely to have a large impact for 3 reasons.
1. FDA Head Resignation
2. Multi-Year Ban Process/Lawsuits
The first and most significant aspect towards this is the resignation of Scott Gottlieb, the FDA Chief. Scott Gottlieb was considered one of the most anti-tobacco FDA chiefs of recent years, and it was him who originally proposed the menthol ban and began to move it forward. The resignation of him means that it's unlikely the menthol ban will move forward, let alone at the same rate.
Another major impediment to a menthol ban would be how long a ban would take. Even if the process of the ban was started today, it would take several years for the ban to move through. That doesn't count the fact that such a ban would be heavily challenged in the courts through lawsuits.
As a result, realistically, if such a ban were to happen, it wouldn't begin to affect things until 2022-2023, which leaves significant time for British American Tobacco to address things.
The last major reason I believe that a menthol ban will not have significant long-term effects is because people using menthol cigarettes are addicted. The 25% risk to earnings potential assumes that everyone who was using a menthol cigarette suddenly stops smoking. However, the addictive part of cigarettes isn't menthol it's nicotine. As a result, I find it likely the majority of these people switch to regular BTI cigarettes.
This switch should mean earnings will continue for British American Tobacco.
As can be seen, British American Tobacco achieved strong 2018 results, and the menthol risk is likely overblown. Let's discuss how all of this ties to the company's financials.
British American Tobacco Financials - British American Tobacco Investor Presentation
British American Tobacco, as discussed above, reported adjusted strong results across the board. One of the most significant aspects of this were the increases in the company's adjusted operating margin. It's tough enough being in a business that's declining secularly, but to be in such a business, with growing margins, is exciting to see. This should result in consistently stable earnings.
British American Tobacco FCF - British American Tobacco Investor Presentation
Overall, the company has turned its business into incredibly strong free cash flow. The company is worth approximately $66 billion pounds and generated an astounding $7.7 billion pounds worth of free cash flow. From this, the company paid $4.6 billion pounds worth of dividends. That means that not only is the company comfortably paying its dividend of 7%, but also it's doing that with a payout ratio of just under 60%.
One thing I am disappointed to see from British American Tobacco is the company's continued increase in shares outstanding, which has also negatively impacted its EPS. British American Tobacco's stock price has had a difficult time since early-2018, and especially when the company's dividend went over 8%, I would have liked to see British American Tobacco buy back stock.
The company buying back stock could have saved the company money in dividend stocks while supporting the long-term EPS.
British American Tobacco Earnings Growth - British American Tobacco Investor Presentation
However, overall, British American Tobacco has been turning its earnings power into strong shareholder rewards. Since 2005, despite a strong decline in smoker numbers during that time, the company has managed to more than quadruple its dividend. That 12% dividend per share growth rate is incredibly impressive to see. That combines with the company's strong EPS growth rate and shows the company's commitment to rewarding shareholders.
British American Tobacco had a rough 2018, dropping more than 50% from the start of the year until the end of the year. A significant component of this drop was investor fears about a ban on menthol cigarettes, which make up 25% of the company's earnings. However, I expect the ban on menthol cigarettes is overblown for the reasons that I discussed above.
Going forward, I find the menthol ban increasingly unlikely. The company has rewarded shareholders well since I initially recommended it, and its 7% yield and continued growth mean I believe it will continue to reward shareholders going forward. As a result, I recommend investing in the company.
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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.