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British American Tobacco: 6.6% Dividend Yield, Too Many Tail Risks

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About: British American Tobacco p.l.c. (BTI), Includes: IMBBY, MO, PM
by: Blue Sky Capital
Blue Sky Capital
Hedge fund analyst, long/short equity
Summary

British American Tobacco (BAT) needs its high-single-digit earnings growth, both to deleverage to its target level and for investor returns.

However, we believe earnings growth may actually decelerate to low-single-digits, as BAT struggles both in the U.S. and internationally.

Excluding Reynolds synergies, U.S. profits are only growing mid-single-digits, and there are significant tail risks from Juul, IQOS and the FDA.

Non-U.S. profit growth is already down to low-single-digits, driven by weak markets and the need to invest in Next Generation Products.

At 3,071.5p, BAT has a Dividend Yield of 6.6%, but too many tail risks; Philip Morris, with a 5.7% Yield, offers a more balanced risk/reward.

Introduction

We are initiating our coverage on British American Tobacco (BTI) (referred here as "BAT") with a Neutral rating.

We have written extensively about tobacco stocks since June, when we published our Buy rating on Philip Morris (PM); since then PM has far outperformed Altria (MO) and Imperial Brands (OTCQX:IMBBY), and delivered similar returns to BAT:

BAT Share Price vs. Tobacco Peers (Since 05-Jun)

NB. Based on local currency; GBP/USD rose 1.9% in this period.

Source: Yahoo Finance (27-Nov-19).

Our ratings have successfully captured the upside in PM and the downside in Altria, as well as helped avoid losses in Imperial Brands, although we have missed a 13% gain when we upgraded Altria only to Neutral :

Blue Sky Rating History on Tobacco Stocks

NB. Market data as of 27-Nov-19.

Company Overview

BAT is a global tobacco company active in all regions, with the U.S. being its largest market, with 42.9% of its Profit from Operations (equivalent to EBIT), despite having only 10.9% of its volume:

BAT Revenue & Profit from Ops. by Region (2018A)

Source: BAT results press release (2018).

We are cautious about how BAT reports its results in several ways. Because the U.S. is so disproportionately profitable, group volumes are not a meaningful indicator of profits. BAT only discloses the combined figures for both cigarettes and Next Generation Products ("NGPs") for each region, which limits our visibility on cigarette volume declines. The reorganisation in 2017 also left us with amalgamated regions, such as "Asia-Pacific & Middle East", which limit our visibility on regional developments:

BAT Profit from Operations by Region

Source: BAT company filings.

One regional trend is clear - the contribution from non-U.S. markets to profit growth has been shrinking, even as the base gets larger:

BAT Contribution to Profit from Ops. Growth by Region

NB. Profit growth contribution figures exclude currency.

Source: BAT company filings.

BAT has a reasonably-sized NGP business, including vapour, Tobacco Heated Products ("THP") and modern oral tobacco, with approx. £1.2bn revenues expected in 2019, which implies a 26% year-on-year growth in 19H2. THP was the driver for NGP growth in H1, when vapour revenues shrank slightly:

BAT Next Generation Products Revenues (2018-19)

Note. NGP revenue growth guided to "lower end of 30-50%" for 2019; 30% used here. All figures are as reported and include the impact of currency.

Source: BAT company filings.

BAT has a lead in vapour in Western Europe, but it is a distant #2 in vapour in the U.S., and in THP in general.

We believe BAT is struggling in the U.S. and internationally, as outlined below.

Earnings from the U.S. Market

Excluding synergies from the 2017 Reynolds acquisition, we believe BAT's U.S. earnings are likely growing at mid-single-digits, and may decelerate further.

BAT's total U.S. volume (including NGP) has been declining at 5-6% a year; revenue growth was 1.5% in 2018 and guided to 3-5% in 2019. Profit from Operations is currently growing much faster, due to Reynolds synergies, where $400m in annualised savings were expected by 2020 year-end ($300m was delivered by 2018 year-end), compared to 2017 Profit from Operations of £4,430m, which implies an approx. 5% benefit to current profit growth:

BAT Volume, Revenue & Profit Growth – U.S.

Source: BAT company filings.

BAT announced a new global cost reduction program in September, involving roughly 4% of its headcount (2,300 roles), which likely implies further U.S. savings. However, while BAT's U.S. margin of approx. 50% is still below Altria Smokeables' best-in-class 55% (both based on post-excise revenues), Altria's business is nearly 50% larger and has more economies of scale.

U.S. cigarette industry volume has seen an accelerating decline, with BAT expecting a full-year decline 5.5% (in line with Altria's 5-6%):

U.S. Cigarette Industry Volume Decline Y/Y (2014-19Q3)

Source: Altria results presentation (19Q3).

Both BAT and Altria expect industry volume declines to be in the 4-6% range after 2019, but they also acknowledge the market and regulatory uncertainties involved. Much depends on vapour, as “cross-category movement” (mostly into vapour) contributed approx. 2% to recent volume declines:

U.S. Cigarette Industry Volume Decline by Component (Rolling LTM)

Source: Altria results presentation (19Q3).

With a strong economy in the past few years, U.S. cigarette price/mix has been sufficient to offset volume declines. However, should volume declines remain consistently at 5% or higher, cigarette revenues may be flat or even decline. (Altria Smokeables' net revenues were down 0.9% year-on-year for 2019 Q1-3, though up 1.1% after excise taxes.)

U.S. Tail Risks from Juul and IQOS

BAT’s U.S. business faces tail risks from Juul and IQOS growing significantly among adult smokers.

Juul has continued to leave BAT is a distant #2 in vapour. As of October, BAT's Vype family has a 17.5% value share, including Vuse Alto with 11.1%, far behind Juul's close to 50% share. In addition, Vuse Alto remains more involved in non-tobacco/menthol/mint favours (37% of their 19Q2 shipments), which are the target of a proposed FDA ban due to their role in youth usage:

Juul Volume Share in U.S. Vapour (19H1)

Source: Altria results presentation (19Q2).

The recent regulatory actions against vapour could help cigarette volumes, but it is too early to be sure. While Juul's growth has decelerated overall, it is just as likely that they will become more effective in targeting adult smokers, especially now that they have former Altria executives in key roles.

IQOS may prove a significant disruptor in the medium term, being marketed by Altria and having been launched in two cities (Atlanta and Richmond) in 19H2. The need for the flexibility to invest in IQOS was one of the two reasons for Altria to reduce its 2020-22 EPS CAGR guidance, and Altria notably did not specify a number for either 2020 or for a minimum growth in any given year.

Should Juul and IQOS make further inroads among U.S. adult smokers, it would cannibalise BAT's cigarette sales, and might may be also forced to “invest” more in their own NGPs, putting more pressure on margins.

U.S. Tail Risks from the FDA

BAT also faces tail risks from the FDA, which has had a declared objective to reduce tobacco addiction since July 2017, having proposed measures such as regulating nicotine content in cigarettes and banning menthol flavours. While the FDA's attention has more recently been diverted to vapour, pressures on cigarettes may return, especially if a new president were elected in 2020.

In addition to the FDA, state governments may also be banning menthol, with a ban in Massachusetts having just been signed by its governor, and New York and New Jersey state legislatures discussing similar proposals.

BAT has cited the example in Canada, where menthol was banned gradually during 2015-17, and where BAT claimed 99% of former menthol smokers stayed with cigarettes. However, menthol was only approx. 15% of the Canadian market but about a third of the U.S. market, and there were fewer vapour options to switch to before 2017. (Some anti-smoking advocates have argued for menthol to remain allowed on e-cigarettes for this reason.)

BAT is particularly vulnerable, given menthol cigarettes are approx. 60% of its U.S. revenues and 20-25% of its group EBIT.

Earnings from Non-U.S. Markets

In non-U.S. markets, BAT's volume decline has been markedly higher since 2017, with management comments indicating weaknesses in Europe, the Middle East and LATAM (at different times). While net revenue growth appears only slightly lower, Profit from Operations growth has decelerated, partly due to NGP investment:

BAT Volume, Revenue & Profit Growth – Non-U.S. Markets

Note: All figures include both tobacco & NGP, and are organic and at constant currency.

Source: BAT company filings.

BAT has a good position in vapour in Western Europe, but is far behind in THP in both Japan and Eastern Europe:

  • In Western Europe, BAT leads in the closed-tank vapour market in key countries, with a value share of 11.8% in the U.K., 19.2% in France, and more than 50% in Germany. However, it faces the continuing strength of unbranded, open-tank sales in the U.K. and France, and the risk of Juul succeeding in accelerating its sales
  • In Japan, BAT's glo THP product has a 4.9% volume share of the overall tobacco market, far behind the approx. 17% share held by PM's IQOS
  • In Russia, glo has more than 1% in volume share in Moscow, whereas IQOS has reached approx. 4% share in Russia

For BAT's non-U.S. businesses, the combination of weak cigarette volumes, IQOS competition and NGP spend mean we expect their earnings to continue to grow at only low-single-digits.

Deleveraging Depends on Earnings Growth

BAT needs its earnings to grow at high-single-digits for it to deleverage. Its expected 2019 Free Cash Flow After Dividends of £1.5bn represents just 0.03x of its 2018 net debt of £43.4bn. Its net debt has basically remained unchanged at £45.5bn since the end of 2017, though this was partly due to the impact of currency and changes in accounting standards:

BAT Net Debt Bridge (2018-19H1)

Source: BAT results release (19H1).

Net debt / EBITDA is implied to be around 3.5x at 2019 year-end by guidance.

Valuation

At 3,071.5p, BAT shares are on 9.5x P/E and 9.0% Free Cash Flow ("FCF") Yield based on its 2019 guidance; its Dividend Yield is 6.6% (203p per share):

BAT Net Income, Cashflow & Valuation

NB. 2019 profit based on management guidance of "high-single-digit" adjusted EPS growth (ex. FX) and an 1.2% FX tailwind.

Source: Company filings. Market data as of 27-Nov-19.

In FCF Yield terms, BAT is the cheapest tobacco stock after Imperial Brands; however, its Dividend Yield is similar to Altria's, and only 1% higher than PM's:

BAT FCF Yield & Dividend Yield vs. Peers

Note. BAT and PM figures based on 2019 guidance; Altria on last-twelve months (19Q3); Imperial Brands ("IMB") on FY19 results (ending September).

Source: Company filings. Market data as of 27-Nov-19.

In EV / EBIT multiples (which include debt and minority investments), BAT is in fact more expensive than both Altria and Imperial Brands:

BAT EV / EBIT vs. Peers

NB. All figures based on latest last-twelve months results available.

Source: Company filings. Market data as of 27-Nov-19.

If BAT can continue to grow its earnings at high-single-digits, than it will continue to deleverage, enabling the dividend to be raised eventually and an upward re-rating in its stock, which would imply a substantial upside.

However, if earnings growth were to slow to low-single-digits, all FCF after Dividends would be used to pay down debt, the dividend would only grow at low-single-digits, and investors' annualised return would likely be less than 10% - from a 6.6% Dividend Yield, no re-rating, and the share price growing low-single-digits.

And, with the tail risks mentioned above, there is a meaningful possibility of adverse scenarios where BAT earnings would even shrink.

Conclusion

The tobacco space is undergoing radical changes, with high prices, regulations and NGPs reinforcing each other’s impact.

BAT is struggling both in the U.S. and internationally. Excluding post-Reynolds synergies, its U.S. earnings are likely only growing at mid-single-digits. Its non-U.S. earnings have already decelerated to low-single-digits growth. It is being outcompeted in U.S. vapour and in Tobacco Heated Products. We believe earnings growth is at risk of decelerating to low-single-digits or even shrink.

BAT depends on high-single-digit earnings growth to deleverage; net debt / EBITDA is expected to be a still too high 3.5x at 2019 year-end.

At 3,071.5p, BAT is on 9.5x P/E and the Dividend Yield is 6.6%. Without high-single-digit earnings growth, annualised investor returns will be less than 10%. The valuation is not sufficient for the number of tail risks.

Our rating on BAT is Neutral. We prefer PM (Buy-rated) for its incremental U.S. sales, larger Emerging Markets exposure and superior tobacco heated product. We are Neutral on Altria and Imperial Brands.

Postscript: I write a "Best Income Ideas from Around the Web" bi-weekly newsletter for Seeking Alpha, and you can find the latest edition here.

Note: A track record of my past recommendations can be found here.

Disclosure: I am/we are long PM. 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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