British American Tabacco's (NYSE:BTI) "BATS", H1 2019 results were in line with the trading update guidance management had previously given. Adjusted diluted earnings growth of 7% in constant currency was driven by 4% constant currency revenue growth and operating margin expansion of 110bps. The results were well received by the market, with the stock up ~7% in London. Although well guided for, I believe the market was particularly impressed with the delivery of Reynolds synergies a year ahead of schedule. The synergies were evident in the 360 bps of US margin expansion. Although management has now met synergy targets, there may well be further synergies that can be gained, although we probably won’t get guidance on them. Keep a close eye on those US margins in future results.
Earnings growth was backed by free cash flow generation, with free cash flow relative to net income of 1X on a trailing 12 month basis. Cash generation in this half was impacted by the timing of the MSA payment, which fell into H1 this year. BATS remains on track for strong cash generation for the full year, with management reiterating guidance on free cash flows after dividends “In excess of GBP1.5bn”. Adding back dividends implies a free cash flow yield on the current share price of >9%. This leaves management with some headroom after paying dividends in terms of debt reduction. Net debt to EBITDA is expected to reduce another 0.4X from FY 2018 levels to ~3.6X excluding FOREX movements.
Despite a good set of results, the initial reaction was relatively short lived, with BATS share price declining 7% since the initial spike. News of a potential merger between Philip Morris and Altria dampened sentiment in the sector further. In BATS' case, this likely stemmed from concerns over the potential scale of a Philip Morris / Altria combined entity. Philip Morris’ distribution network could be utilized to grow JUUL internationally. I think these fears are overblown, as the probability of the merger going ahead seems relatively low, given investor unhappiness on both sides of the deal.
BATS trailing dividend yield has climbed to 7% again, with the market completely disregarding the fall in global yields. In fact, the relationship seems to have completely broken down in recent years as regulatory issues remain the core focus of the market. This is particularly perplexing given the dividend certainty, we know mid to high single digit constant currency earnings growth will mean a dividend of ~2.14 British pence at worst for the full year, which means a definitive forward dividend yield of ~7.5% is up for grabs.
Source: Bloomberg, Company data, compiled by analyst
The re-rating potential for BATS is substantial, with a number of potential catalysts, including:
- Restoration of above relationship with global yields. At some point investors must be willing to take on the risk in exchange for the yield on offer.
- Degearing of the balance sheet to more normalized levels (Long term net debt to EBITDA is 2.6X). There’s no doubt part of the de-rating we have seen over the past two years is due to the debt taken on to fund the Reynolds deal.
- Recognition by the market that BATS is in a significantly less risky position than immediately post the Reynolds acquisition. The balance sheet has de-geared from over 5X net debt to EBITDA to 4X. Synergy guidance has been met, the acquisition is bedded down. The dividend is also safe for now with strong free cash flows coming through.
- Any delays by the FDA on implementation of proposed regulation. The key proposals are the nicotine reduction and menthol bans. The FDA may also target JUUL directly in the vaping category (Given quite compelling evidence pointing towards increased teenage vaping using the JUUL product), which may indirectly benefit BATS vaping business in the US.
Source: Company data, compiled by analyst
Re-rating to the long term average dividend yield of 4.4% implies 58% upside to the current share price. I’m not suggesting this as short term upside, rather long term potential as management work through the various issues impacting the rating. What investors can bank on in the short term, however, is the 7.5% dividend yield over the next year, and ~7% constant currency earnings growth (Strong pricing power in US should allow for low single digit top line growth, while management can continue to extract 50 – 100 bps of margin expansion p.a.). Barring any further derating in the share, this makes for an attractive return of ~14% p.a. with potentially much higher returns over the longer term. The current entry price represents a good entry point for a long term holder.
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.