British American Tobacco: A 6.7% Yielding Blue Chip That's Up 23% With More Room To Run

Dec. 12, 2020 7:00 AM ETBritish American Tobacco p.l.c. (BTI)59 Comments

Summary

  • It’s true that BTI still gets 95% of sales from traditional tobacco products compared to Phillip Morris’ (PM) 75%.
  • But management is working hard to get to the same cigarette-free future the industry envisions.
  • The whole industry knows very well that nicotine is the long-term future of tobacco, not cigarettes.
  • BTI specifically plans to tap into the almost $500 billion global nicotine market – which is growing at 4% CAGR.
  • Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Get started today »

In my personal constant quest for value, both in REITs and ordinary stocks, I’m always seeking out the highest quality names with a goal of building a diversified basket of stocks, with an overweight allocation to REITs.

Usually once a week I will lean outside of my circle of competence and examine a non-REIT in hopes of further diversifying my retirement portfolio and help other readers on Seeking Alpha.

So, this week I decided to peel back British American Tobacco (NYSE:BTI), a so-called “tobacco” company that I purchased shares back in late October. To help break it all down, Dividend Sensei helped me coproduce this article, and he starts out reminding readers that this company is not really a “tobacco company.”

Source

For starters, up at the top of its homepage, it abbreviates its name to BAT. And underneath the subsequent logo reads: “A Better Tomorrow.”

Beneath that are links with titles like:

  1. “Human Rights Report is an industry first.”
  2. “An evolved strategy with a clear purpose.”
  3. “Transforming, investing, and growing.”

Admittedly, that second one includes a half-picture of tobacco leaves. But for those who don’t automatically know what they look like, it’s easy to assume it’s any other plant.

Even its About page begins with this:

“We are a leading, multi-category consumer goods business. Our purpose it to build a better tomorrow by reducing the health impact of our business through offering a greater choice of enjoyable and less risky products for our consumers.”

Here are a few other things you can reap from that section of its website:

  • It’s a leading FTSE company spread across six continents.
  • It employs more than 53,000 people worldwide.
  • And yes. It does sell cigarettes.

In fact, its “heritage – and the foundation of (its) success – is in cigarettes.” However, it adds:

“Our ambition is to have 50 million consumers of our non-combustible products by 2030 and to accelerate the growth of our New Category revenues at a faster rate than our total revenue, reaching £5 billion in 2025.”

So how are those plans working out for it? And is it a good play?

That’s precisely what this article is designed to discuss.

A British American Tobacco Base

On Oct. 28, BTI closed at $31.83 and a:

  • 6.9x 2021 consensus earnings
  • Safe 8.4% yield
  • 58% discount to fair value
  • 32.3% five-year analyst consensus return potential
  • 23.1% five-year risk-adjusted expected returns

In other words, the stock was priced for -3.2% compound annual growth rate expectations.

Since then though, people woke up to the absurdity of that idea, sending the stock rocketing 24% higher. It outperformed the S&P 500 by 2x during the best November for stocks in 33 years.

Even so, it remains 49% undervalued: One of the best blue-chip bargains on Wall Street right now.

If BTI grows as analysts expect and returns to historical mid-range fair value, we would see 172% total returns, or 21.9% CAGR, in the next five years. The S&P 500, meanwhile, would yield just 3.3%.

Think that sounds unfoundedly optimistic? Consider how its investors have prospered from its bear market lows in the past. From 2000 to 2015, the stock saw total returns of 2,742%.

(Source: Portfolio Visualizer)

That’s the power of anti-bubble blue-chip investing, which allows the average investor to achieve Buffett-like returns with very little fundamental risk. More importantly, it allows you to maximize safe and growing income over time – which can make the difference between retiring in splendor, retiring in comfort, or not retiring at all.

Just take a look at BTI's track record on delivering dependable income and growing shareholder wealth. Since 1986, it’s proven to be a compounding machine.

(Source: Portfolio Visualizer)

A mere $1,000 invested in 1986 is worth $80,322.80 today, with a yield on cost of 554.6% at the end of last year.

A Pretty Safe Status, and Getting Better Still

Today, even in the middle of one of the most convoluted market conditions ever, we’re still giving it a safety score of 71% with a 4/5 above-average label.

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This score is based on the 58-point Dividend Kings Safety Model.

Speaking of safety, S&P downgraded BTI from A- to BBB+ way back in January 2017. That was due to the company’s “agreement to acquire the remaining 57.8% stake in U.S.-based Reynolds American Inc.” On the one hand, it felt that move would “weaken its credit metrics.” Then again:

“In our view, BAT is well positioned to complete this strategic $49 billion acquisition by the end of third-quarter 2017. We believe the combination… will enhance the group's business profile, increasing its presence in the U.S. and the potential for scale-related margin improvement, with only modest integration risks…

“The stable outlook reflects our view that BAT will be able to restore credit metrics in line with the 'BBB+' rating within 24 months after the transaction closes on the back of strong cash flow generation…”

But the ratings agency wanted it to bring its 1) adjusted debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) down to 3x or less and 2) discretionary cash flow to debt to 10%-15%. British American’s 13-year median debt/EBITDA ratio is 1.96.

That’s one of the reasons it was an A-rated company before it levered up become the global king of menthol – and the biggest tobacco company on earth. And its historical interest coverage is 7.3, which is well within the 6.7-10 range rating agencies consider safe for the industry.

Plus, it clearly wants to see an upgrade in its cards. So it’s been working hard toward that goal, as evidenced by its deleveraging front, which bodes well for the safety of this 6.8% yielding blue-chip itsQ4 business update.

The report showed that its constant currency adjusted revenue growth should come in at the high end of the 1%-3% range thanks to expectations of:

  • A reduction in expected revenue headwind from COVID-19
  • An improved full-year global industry cigarette and tobacco heating product (THP) volume decline
  • Its U.S. industry to be broadly flat instead of down
  • Mid-single figure constant currency adjusted diluted EPS growth
  • Continued deleveraging of the balance sheet to around 3x adjusted net debt to adjusted EBITDA by the end of 2021
  • A dividend payout ratio of 65% of adjusted diluted earnings per share and growth in sterling terms, supported by a strong liquidity position

In other words, BTI's deleveraging plans are on track. And its dividend safety should steadily improve over time as well.

British American’s Tobacco

It’s true that BTI still gets 95% of sales from traditional tobacco products compared to Phillip Morris’ (PM) 75%. But management is working hard to get to the same cigarette-free future the industry envisions.

Jack Bowles says:

“We continue to be clear that combustible cigarettes pose serious health risks, and the only way to avoid these risks is not to start or to quit. BAT encourages those who would otherwise continue to smoke to switch completely to scientifically substantiated reduced-risk alternatives.

“We are growing our new-category business as fast as possible. And we are proud to now have around 13 million non-combustible product consumers. We are confident about the future for BAT and are committed to our 2025 new-category revenue ambition of (£5 billion).

The whole industry knows very well that nicotine is the long-term future of tobacco, not cigarettes. That’s why Finance Director Tadeu Marroco added that its:

“… Vuse/Vype is the fastest-growing international vapor brand growing value share of its top five markets by over (seven) percentage points to 26% year-to-date. The brand has now achieved value share leadership in closed systems in four of the five large vapor markets, exceeding 50% value share in two of them. Vuse/Vype is (No. 1) in device sales in all top five markets with device volume share in excess of 50%.”

Vuse also is the fastest-growing brand in the U.S. “with a 24% value share of total vapor year-to-date.” And its making its presence known in Canada as well.

Clearly then, the company is justified in “investing an additional £450 mm in new categories…” BTI specifically plans to tap into the almost $500 billion global nicotine market – which is growing at 4% CAGR.

As things stand now, the company already is doing well in reduced-risk products.

(Source: PM investor presentation)

British American also is planning a U.K. test of a CBD vaping product. And it's introducing mini pouches of its nicotine-kicking Modern Oral in Sweden, Norway, Slovakia, and Switzerland – with plans to expand to another six markets in the next few months.

For this reason and so many more, we’re giving it an overall quality score of 71%, making it a 9/12 blue-chip stock.Table Description automatically generated

Of course, we also want to know more about its peer position. So here’s some data along those lines.

(Source: Gurufocus)

BTI's average profitability already is in the top 38% of its industry and improving. Here’s what it looks like now, broken down by metric:

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Return on capital – which is essentially all the money it takes for a company to operate – is legendary investor Joel Greenblatt's gold standard proxy for quality and “moatiness.” Because the weighted cost of capital for the S&P 500 is about 8% over time, that’s also the rule of thumb for average-quality companies’ ROC.

Meanwhile, what Dividend Kings labels as super and ultra SWANs (sleep well at night stocks) feature 85% ROC. And BTI’s?

BTI’s 12-month trailing ROC is 187%, which puts it in the top 16% of its industry. Just six companies are better in this regard.

Oh, and it might also be worth mentioning that its Q3 figure was up to 191%. Admittedly, its 13-year median is “only” 164%.

But, hey. That’s still almost 3x that of its peers outside recessions. Besides, ROC grew 11% CAGR over the last five years as cost-cutting initiatives following the Reynolds purchase is almost complete.

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BTI is currently trading at a 51% discount to next year's fundamental consensus and a 48% discount when accounting for the current dividend. As such, a return to average historical fair value by the end of 2023 would result in a 37% CAGR total return (including dividends).

British American Tobacco Risk Profile: Why BTI Isn't Right for Everyone

British American Tobacco's fundamental risk is relatively low, with S&P, Fitch, and Moody's estimating about 5% to 7.5% 30-year bankruptcy risk. However, that doesn't mean it doesn't have a complex risk profile to be aware of.

Morningstar actually just raised its uncertainty rating on the company from low to medium. That’s:

“… because of the heightened risk to the business model posed by emerging categories. Although we expect Big Tobacco to ultimately dominate across all tobacco and nicotine categories, it is not yet clear how profitable the new categories will be. There is little visibility into the tax structure in heated tobacco globally, for example, which creates a wider range of outcomes than has historically been the case in tobacco.”

And there are legal risks too, since it could always be sued for adverse effects of smoking. For the most part, regulations shouldn’t be an issue considering how they can actually limit competition, lower costs, and strengthen pricing power in certain cases.

But Morningstar is worried about the “plain packaging” movement, which doesn’t allow cigarettes to come in attractively-designed boxes.

“… we believe it could lead to trading down, which would erode pricing power. British American's portfolio is balanced across price points, which is likely to provide some insulation from trading down, but we would be concerned about the global industry profit pool if the plain packages are introduced in other major markets.”

And there’s also this factor to consider:

“British American's reporting currency is the British pound, but it only generates around 1% of sales in Britain. It also has exposure to currencies too small to hedge in large amounts on the open market. Britain is not a major source of tobacco leaf, so a very small percentage of the company's operating costs is denominated in sterling, meaning that the firm is highly exposed to a strengthening of the British pound."

As for valuation risk, even the most conservative fair value estimate puts BTI at $51. Yet it’s trading at $39, indicating very low long-term valuation risk. So we consider little room to worry there.

Volatility risk, of course, is a different story. That’s always going to be present to some degree or another.

The average company’s 15-year annual volatility, after all, is 28%. And the average aristocrat’s is 23%.

BTI’s, meanwhile, is 21.8%, which is good. But still present nonetheless. So, knowing that we could be in store for a double-dip pandemic-induced recession or – more likely – a more mild downturn, it’s important to keep your sanity safe and sound in order to keep your portfolio the same way.

So how about keeping this figure front and center: If BTI grows as expected over the next 30 years, there’s an 80% statistical probability your money will grow by 4.3 to 143x.In short, prudent long-term investors who own it as part of a diversified and prudently risk-managed portfolio have a lot to gain here. Quality plus sound risk management is what lets you sleep well at night no matter what the economy or stock market do. It gets you through the tough times so you can reach the long term, where fundamentals determine 91% of stock returns.

In which case, BTI should do just fine. And then some.

Bottom Line: British American Tobacco Is the Best Blue-Chip Deal on Wall Street

We can't tell you when BTI will fully return to fair value, but we can say we’re certain it eventually will.

The 23% rally in the last six weeks isn’t just impressively good news for existing investors. It's likely a taste of things to come. Just as soon as the market fully flips from fear to greed.

The results can be spectacular, such as the 22% CAGR returns analysts expect from BTI over the next five years.

Those kinds of gains don't require any kind of extraordinary magic on the part of BTI. Just a consistent execution of its long-term plan will do – which it’s continued to deliver throughout its second-worst bear market in history.

In this 39% overvalued market, when bubbles are all around us, buying quality anti-bubble blue-chips like British American Tobacco can be a great way to achieve and even surpass your financial goals.

That’s our story, and we’re sticking to it.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: written and distributed only to assist in research while providing a forum for second-level thinking.

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This article was written by

Brad Thomas profile picture
103.83K Followers
Author of iREIT on Alpha
The #1 Service For Safe and Reliable REIT Income

Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 6,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.

The WMR brands include: (1) The Intelligent REIT Investor (newsletter), (2) The Intelligent Dividend Investor (newsletter), (3) iREIT on Alpha (Seeking Alpha), and (4) The Dividend Kings (Seeking Alpha). Thomas is also the editor of The Forbes Real Estate Investor and the Property Chronicle North America.

Thomas has also been featured in Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, and 2019 (based on page views) and has over 102,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley). 

Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha (2,800+ articles since 2010). To learn more about Brad visit HERE.

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.

Additional disclosure: DS is long BTI.

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