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British American Tobacco's Valuations Look Cheap At The Current Price

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About: British American Tobacco p.l.c. (BTI)
by: Anusuya Lahiri
Anusuya Lahiri
Tech, chipmakers, media, telecom
Summary

Gaining market share in the U.S. despite competition from Marlboro and JUUL.

Strategizing towards gradual expansion in every potential growing region.

Compelling dividend payouts and cash flows.

Strategic acquisition of RAI adding to the topline,bottomline and valuations.

Mytarget price for BAT is $53.4 which is 14-18 times my projected EPS during fiscal2019 and 2021.

BAT’s Key Business Segments

British American Tobacco (or BAT) (BTI) is a leading provider of tobacco and nicotine products. Its assortment of products is categorized under:

BAT’s Strategic Portfolio include:

  • the eight Strategic Combustible Brands (or SCBS) like Kent, Dunhill, Lucky Strike, Pall Mall, Rothmans, Camel (U.S.), Newport (U.S.) and Natural American Spirit (U.S.) and
  • Potentially Reduced-Risk Products (PRRPs), which include THP, vapor, modern white oral products and traditional oral products like moist snuff and snus.

Other international and local cigarette brands include Vogue, Viceroy, Kool, Peter Stuyvesant, Craven A, Benson & Hedges, John Player Gold Leaf, State Express 555 and Shuang Xi.

Revenue Contribution of the Key Segments

Revenue contribution of the SCBs improved from 56.2% in fiscal 2017 to YoY in fiscal 2018. They generated 64% of the revenue in the first half of fiscal 2019.

The PRRPs' revenue contribution expanded from 4% to 7.3% between fiscal 2017 and fiscal 2018. It further increased to 8.5% in the first half of fiscal 2019.

The consolidated Strategic Portfolio revenue contribution improved from 60.2% in fiscal 2017 to 70.5% in fiscal 2018. The revenue contribution was 72.6% in the first half of fiscal 2019.

Other international and local cigarette brand revenue contribution declined from 39.8% in fiscal 2017 to 29.5% in fiscal 2018. The contribution stood at 27.4% in the first half of fiscal 2019.

Therefore, the 26.9% YoY revenue growth in fiscal 2018 was triggered by the 48.6% YoY growth in the Strategic Portfolio partially offset by the 5.9% YoY decline in the other cigarette brands. Similarly, the 8.7% YoY growth of the Strategic Portfolio partially offset by the 5% YoY decline in other cigarette brands drove the 4.6% YoY revenue growth in the first half of fiscal 2019.

The Combustible Portfolio and the New Categories expanded by 42.6% YoY and 138.2% YoY respectively. They improved by 7% YoY and 31.3% YoY in the first half of fiscal 2019.

Source: Co. filings

Regional Revenue Generation of the Key Segments

Revenue contribution from the U.S. increased from 21.5% in fiscal 2017 to 38.8% in fiscal 2018. The revenue contribution stood at 41% in the first half of fiscal 2019.

Asia-Pacific and the Middle East (or APME) revenue contribution decreased from 25.8% to 19.9% between fiscals 2017 and 2018. It remained at 19.8% in the first half of fiscal 2019.

Americas and Sub-Saharan Africa (or AmSSA) revenue contribution dipped from 22.4% in fiscal 2017 to 16.8% in fiscal 2018 and stood at 16.6% in the first half of fiscal 2019.

Europe and North Africa (or ENA) generated 30.3% of the revenue in fiscal 2017 and slipped to 24.5% in fiscal 2018 and 22.7% in the first half of fiscal 2019.

Source: Co. filings

Segment-wise Volume Growth

The volume contribution of Strategic cigarettes has grown from 55.5% in fiscal 2017 to 62.7% in fiscal 2018. It remained at 62.9% in the first half of fiscal 2019.

Other cigarette brand volume contribution dropped from 44.2% in fiscal 2017 to 36.3% in fiscal 2018. It stood at 36% in the first half of fiscal 2019.

THP constituted 0.3% of the volume in fiscal 2017. The volume contribution grew to 1% in fiscal 2018 and 1.2% in the first half of fiscal 2019.

Therefore, the 16.7% YoY and 217% YoY growth in Strategic cigarette volume and THP volume respectively partially offset by the 15% decline in other cigarette volume drove the 3.3% YoY volume growth in fiscal 2018. While the 0.8% YoY and 8.5% YoY degrowth in Strategic cigarettes and other cigarette volumes respectively partially offset by the 17.2% YoY volume growth in THP led to the 3.5% YoY volume decline in the first half of fiscal 2019.

Source: Co. filings

Region-wise Volume Growth

Volume contribution from the U.S. rose from 5.2% in fiscal 2017 to 10.9% in fiscal 2018. It stood at 10.8% in the first half of fiscal 2019.

APME’s volume contribution dropped from 33% in fiscal 2017 to 32.2% in fiscal 2018 and stood at 33.7% in the first half of fiscal 2019.

Volume contributed by AMSSA dipped from 24.2% in fiscal 2017 to 22.2% in fiscal 2018 and remained at 22.1% in the first half of fiscal 2019.

ENA generated 37.6% of the volume in fiscal 2017 compared to 34.7% in fiscal 2018 and 33.4% in the first half of fiscal 2019.

Therefore, ENA, APME followed by AMSSA generated close to 95% of the volume in fiscal 2017 which declined to 89% in fiscal 2018. Their volume contribution marginally declined from 90% in the first half of fiscal 2018 to 89% in the first half of fiscal 2019.

However, the U.S. posted a YoY growth of 118% in fiscal 2018 and its volume contribution rose from 5.2% in fiscal 2017 to 10.9% in fiscal 2018. The contribution rose from 9.9% in the first half of fiscal 2018 to 10.8% in the first half of fiscal 2019.

Source: Co. filings

Analyzing the Income Statement

BAT’s net revenue expanded by 38.5% and 25.2% YoY in fiscals 2017 and 2018 respectively after just a 12.7% YoY growth in fiscal 2016. A strategic acquisition, a 6% price mix on combustibles and growth in vapor, THPs, modern and oral drove the fiscal 2018 growth partially offset by the cigarette volume degrowth. The acquisition of Reynolds American (or RAI) played a very potent role in driving the top line and bottom-line numbers. RAI had posted net revenue of $12 billion each in fiscals 2017 and 2016. RAI recorded net revenue growth of 128% YoY in fiscal 2018. RAI’s net income also grew from $6 billion in fiscal 2016 to $7 billion in fiscal 2017.

BAT’s net revenue grew by 11.2% YoY in the first half of fiscal 2017. However, it grew by 56.9% in the first half of fiscal 2018 after beating the industry growth rate with its cigarette and THP portfolio.

The net revenue posted a 4.6% YoY growth in the first half of fiscal 2019. A price mix of 7% across the cigarette along with growth in new categories and traditional oral products drove the growth partially offset by the decline in cigarette volumes.

Source: Co. filings

Compelling margin expansion amidst competition

The gross margin expanded from 74% in fiscals 2016 and 2017 to 81.4% in fiscal 2018. The margin expanded to 83% in the first half of fiscal 2019.

The EBIT margin had expanded from 33% in fiscals 2016 and 2017 to 38% in fiscal 2018. The margin remained at 36% in the first half of fiscal 2019.

The EBITDA margin improved from 37% in fiscals 2016 and 2017 to 42.3% in fiscal 2018. It stood at 40.3% in the first half of fiscal 2019.

The PAT margin (excluding RAI’s profits) rose from 18.5% in fiscal 2016 to 23.6% in fiscal 2018 and stood at 21.7% in the first half of fiscal 2018. The PAT margin attributable to the owners upon inclusion of RAI’s profits declined from 32.9% in fiscal 2016 to 24.6% in fiscal 2018 and stood at 23% in the first half of fiscal 2019.

The dividend payout looks compelling at 77% in fiscal 2018 compared to PMI at 88% and Altria at 81.4%.

BAT is making serious efforts to expand its product offerings to the regions which are showing promise and exploring newer markets as well.

Why BAT Compared to PMI, Altria?

BAT has posted a very compelling net revenue growth rate compared to its peers. BAT's gross and EBITDA margins also appear more consistent compared to the peers.

BAT’s revenue contribution from cigarettes declined from 96% in fiscal 2017 ($18.5 billion) to 92.7% in fiscal 2018 ($22.7 billion). The newer smoking category revenue expanded from 4% ($0.8 billion) to 7.3% ($1.8 billion) for the periods. Cigarette and newer smoking categories contributed 91.5% ($11.1 billion) and 8.5% ($8.8 billion) of the revenue in the first half of fiscal 2019 respectively.

A growth of 3.2% and 3.3% in cigarette and THP shipment volume associated with RAI’s acquisition drove the fiscal 2017 and 2018 revenue growth respectively. However, the volume declined by 3.5% in the first half of fiscal 2019.

U.S. revenue contribution expanded from 21.5% in fiscal 2017 to 41% in the first half of fiscal 2019. Asia-Pacific and the Middle East (or APME) revenue contribution decreased from 25.8% in fiscal 2017 to 19.8% in the first half of fiscal 2019. Americas and Sub-Saharan Africa (or AmSSA) revenue contribution dipped from 22.4% in fiscal 2017 to 16.6% in the first half of fiscal 2019. Europe and North Africa (or ENA) generated 30.3% of the revenue in fiscal 2017 and 22.7% in the first half of fiscal 2019.

Philip Morris International (or PMI) (PM) cigarette revenue contribution declined from 87.3% in fiscal 2017 ($25.11 billion) to 86.2% in fiscal 2018 ($25.53 billion). It stood at 81.6% in the first nine months of fiscal 2019 ($18.04 billion). Reduced Risk Products generated 12.7% ($3.64 billion), 13.8% ($4.1 billion) and 18.4% ($4.1 billion) of the revenue during fiscal 2017, 2018 and nine months of fiscal 2019 respectively.

The cigarette and HTU volume degrowth slowed down from 2.7% in fiscal 2017 to 2.1% in fiscal 2018 and further slipped to 0.9% in the nine months of fiscal 2019.

European Union’s revenue contribution rose from 28.9% in fiscal 2017 to 33.4% in the nine months of fiscal 2019. Eastern Europe's contribution expanded from 9.4% to 10.4% between the periods. The Middle East & Africa generated 13.9% of the revenue for the periods. South & Southeast Asia contributed 15.4% and 16.3% of the revenue for the periods. East Asia & Australia's revenue contribution dropped from 22.2% in fiscal 2017 to 18.5% in the nine months of fiscal 2019.

Source: Co. filings

Altria’s (MO) smokeable products (including cigarette and cigar) contributed 88.5% ($22.64 billion), 87.9% ($22.3 billion) and 88.2% ($16.84 billion) of the revenue in fiscal 2017, 2018 and nine months of fiscal 2019. The smokeless products contributed 8.4% ($2.2 billion), 8.9% ($2.3 billion) and 9.2% ($1.8 billion) of the revenue respectively. Wine and others generated 3.1%, 3.2% and 2.5% of the revenue respectively.

Altria’s smokeable product shipment volume posted degrowth of 5%, 5.7% and 6.7% in fiscal 2017, 2018 and nine months of fiscal 2019. The smokeless product shipment volume recorded degrowth of 1.4%, 1% and 2.8% for the periods.

Altria mainly caters to the U.S. markets.

Source: Co. filings

What is in store for BAT?

BAT competes with popular cigarette brands like Marlboro and e-cigarette brands like JUUL. Despite that, the revenue contribution from the U.S. rose from 21.5% in fiscal 2017 to 41% in the first half of fiscal 2019. It generated 78.5% of its revenue from the non-U.S. countries in fiscal 2017 and 59% in the first half of fiscal 2019 respectively.

Interestingly the strategic cigarette volume contribution rose from 5.2% in fiscal 2017 to 10.8% in the first half of fiscal 2019. The volume contribution of the non-U.S. regions has remained flat during the periods.

Some activities and observations concerning BAT in fiscal 2019:

  • Expected cigarette and THP industry volume degrowth of 3.5% in fiscal 2019 against industry degrowth of 5.5%
  • Expected new category revenue growth within an average of 30% to 50%
  • Reduction of combustible SKUs by 10% excluding the TPD implementation in Europe
  • Growth in value share, premium share and ASU30 (or Adult Smokers Under 30) share driven by volume growth in the premium segment of Newport and NAS
  • Rollout plans for Velo in the U.S.
  • The conception of a 2.4-milligram nicotine variant of Vuse Alto for the U.S.; an exclusive promotion offer of $0.99 for Vuse Alto power kit in the U.S.
  • Leading position in the retail vaping market in France
  • Germany and Canada exuded potential for Vype
  • Market share gain in oral tobacco markets of Scandinavia and newer oral markets like Denmark and Switzerland
  • Market-leading position in the oral market of Sweden and Norway
  • Glo has displayed potential in Japan
  • Prioritization of THP innovation in Japan due to its positive results; flavor capsules are also doing very well in Japan
  • Launch glo pro, glo nano and glo sens in Asia in the second half of fiscal 2019
  • Amalgamation VUSE and Vype into the VUSE portfolio by the end of 2020
  • Launch EPOK and Lyft in markets outside the U.S. in the second half of fiscal 2019

From the above, we can understand that BAT is expanding its presence across every potential region for growth.

Source: Exchange, Author estimates

BAT's Valuations look compelling at the last CMP

From the above observations, I have projected a net revenue growth rate of 18%, 15% and 10% for BAT during fiscal 2019, 2020 and 2021. The volume-price mix and cost control are expected to translate into gross margin growth over the medium term. The employee costs will decrease due to the job cuts announced by the company. The profits from associates and joint ventures have been excluded from the calculations to get a better view of the company’s organic growth capabilities. The increase in debt during fiscal 2017 to fund the acquisition of RAI led to the rise in the borrowing costs of the company.

Taking the above into consideration we can still expect a growth in the EBIT and EBITDA margins. The company’s impressive operating cash flows ($10.3 billion in fiscal 2018 and $2.3 billion in the first half of fiscal 2019), aided by minimal capital expenditure, partially offset by the debt repayment and interest obligations has translated into compelling dividend payouts. The slew of initiatives undertaken in fiscal 2019 is expected to add to the profit margins considering the growing popularity in newer forms of smoking.

Source: Co. filings, Author estimates

Cheap valuation at the CMP

My DCF model based on the above observations is pointing towards an upside of 53% on the last closing price of $34.96. My target price for BAT is $53.4 which is 14-18 times my projected EPS during fiscal 2019 and 2021; quite cheap!

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.