Stock Analysis

British American Tobacco – Will it help you in building a better tomorrow?

British American Tobacco Plc ($LON:BATS) is last on the list of the Noble 30 Index, but definitely not the least. Today I will share with you myย quick analysisย about the British American Tobacco (BAT) and asses whether I find BAT shares interesting to consider buying at the current share price.

Background

British American Tobacco was founded in 1902 after a joint venture of Imperial Tobacco Company (UK) and the American Tobacco Company (US). As the name suggests, it’s still today in its core a tobacco company selling a wide range of cigarettes brands.

Actually, the company became one of the largest cigarettes producers in the world after its acquisition of Reynolds American back in 2017.

The below picture is an overview of their current brands which exists out of non-Combustible (i.e. vaping) and Combustible (traditional cigarettes) products. I think that some of you might recognize them even when you don’t smoke, i.e. Vype, Camel, Dunhill, Lucky Strike and Pall Mall.

British American Tobacco brands

This brand portfolio means that the company owns a wide variety of brands and products which gives them a good diversified portfolio for into the future. And looking at the future: the normal cigarette is not dead yet, but the predictions are that next generation products like vapor and tobacco heating will be the main growth drivers of the industry. The below picture illustrates this ๐Ÿ‘‡


I wanted to also call-out the following text from the research report from Grand View Research:

The global tobacco market size was valued at USD 849.09 billion in 2019 and is expected to grow at a compound annual growth rate (CAGR) of 3.1% from 2020 to 2027. The market is gaining momentum and witnessing a high demand owing to rising consumer disposable income, increasing number of product launches, and availability of superior-quality products. Increasing consumption of tobacco products among females and students is also fueling market growth. According to the American Lung Association, the use of tobacco products has increased from 28.2 percent to 31.2 percent among high school students from 2002 to 2019 in U.S.

Source: https://www.grandviewresearch.com/industry-analysis/tobacco-market


I am not too happy though that some of this growth is being based on the increasing popularity of these next generation products among high school students. I’m a non-smoking person and a parent as well and I wouldn’t want my own children to start smoking. But this is where the paradox of investing comes in and especially when investing in sin-stocks, because I’m OK with having sin-stocks in my portfolio.


Competition

Let’s get back to the company again. British American Tobacco’s biggest competitors are Altria ($MO), Philip Morris ($PM) and Imperial Brands ($LON:IMB). And the competition is very tough at the moment, because everyone wants a piece of the pie for these new innovative products.

Most recently we’ve seen this with Altria taking a 35% stake for $12.8bn in Juul Labs, which in hindsight was a very dubious investment at a very large price. Especially when the US health department not long after started to forbid the different flavors which made Juul’s products very popular and profitable, especially among teenagers.

At the same time British American Tobacco is suing Philip Morris for patent infringement with their popular iQOS product. This is an important move, because the FDA authorized the marketing of iQOS and its heating system with “reduced exposure” information.

British American Tobacco has to act quick, because it is at risk of losing out on a potentially large share in the US market for its Glo brand. A first-movers advantage will be very beneficial and in this case it might just go to Philip Morris.

In my opinion Philip Morris has a lead time to British American Tobacco by entering the US market for about 1 to 1,5 years. Glo still needs to be submitted for FDA approval.

Purpose and Strategy

How do you evolve as a Tobacco company into a company that people start to like and accept again? Well, just listen to all your stakeholders, innovate and add value to their lifes.

The elephant in the room is always the negative health impact from smoking and this is something that British American Tobacco started to embrace and wants to improve on. This is now at the heart of their recently revised strategy:


Having said that, In 2019 British American Tobacco earned in total ยฃ25.8 billion in revenue which was 5.7% more than in 2018. These are very high growth numbers for a company which by many is perceived of operating in a declining industry.

British American Tobacco Dividend Safety

Is their dividend safe?ย Thatโ€™s the main question that I want to answer as a dividend growth investor when considering to buy BAT shares. Let me therefore explore several determining factors first and then get back to you with my answer.

British American Tobacco Dividend history

British American Tobacco has a relatively strong dividend growth track record. It has grown its dividend at least since 2000, hence BAT shares increased their dividend for 20 consecutive years.

I also found their average 10 year growth rate quite reasonable for such a stable company. The average dividend growth ratio was 5.82% which is close to my desired average growth of 6% which I seek for my portfolio.

BAT shares dividend growth history
British American Tobacco: 10 year dividend history

BAT shares – Earnings / Cash Flow

Their earnings / cash flow have been steadily growing over the last decade. They effectively doubled which according to the rule of 72 means that they grew with ~7% per year over time. I consider this as pretty good numbers.

Just to clarify, the reason for the large spike in EPS in 2017 was due to accounting movements related to the acquisition of Reynolds American in the year and the impact of the US tax reform.

British American Tobacco Earnings and Cash Flow 20 year history
British American Tobacco: 10 year EPS and Free Cash Flow per share history

The EPS payout ratio and FCF payout ratio have generally hovered in a band between 55% and 75%. This is in line with their dividend payout policy of 65%.

These EPS / FCF numbers are pure growth numbers without financial engineering, because the company hasn’t been buying back BAT shares except for 750 mln in 2014. It actually issued some shares (~10%) in 2017 to fund the Reynolds American acquisition.

There is some Covid-19 impact though related to the lockdowns and for instance a ban on cigarettes in South Africa. Therefore the company has revised their earnings forecast from a high-single-digit growth into a mid-single-digit growth. I mean, it’s still growth during these extraordinary times!

Long Term debt

Long Term debt has declined in 2019 but don’t be fooled by the graph, because current liabilities have been increased at a similar absolute amount. Hence, I consider the amount of debt being relatively flat since 2017.

British American Tobacco Long Term Debt trend

There are two big spikes in their long-term debt and they are both easily explainable:

  1. 2014-2015: the company had to invest additional (4.5 bln) to preserve their stake in Reynolds American Inc
  2. 2016-2017: the company used mainly leverage to fully purchase Reynolds American Inc

Now what does this tell us? Is the company getting in trouble? The EPS / FCF didn’t grow at a similar rate to debt, right?

Well, for that I prefer to look at the development of the debt/equity ratio. British American Tobacco did got assets and equity in return when purchasing Reynolds American.

Having said that, the debt/equity ratio currently stands at 59% which I find a healthy level. The debt to equity ratio stood at 202% in 2016 pre-merger/acquisition.

My conclusion: from a balance sheet point of view the acquisition seems to have been quite prudent.


Now, is the dividend safe?

I believe so. As you saw, the dividend has been growing at similar rates to EPS and FCF. They have not been borrowing money for share buybacks and such, but rather to buy additional assets and a strong position in the US market.

New generation cigarettes are the main catalyst for the whole industry, but British American Tobacco needs to speed up their FDA approval for Glo, because it’s at risk of losing market share in the US.

This risk is the main reason why the share price has been on a downward trend since the FDA announcement on 7 July.

BAT shares price
Share price development since FDA approval.

Did this give us as dividend growth investors a buying opportunity?

BAT shares – Fair Value estimation

I am positively surprised about British American Tobacco as a company. I actually didn’t really know the company before and it only caught my attention by being a Noble 30 member.

So let’s do two quick checks via the Dividend Discount Model (DDM) and a Discounted Cash Flow calculation.

DDM valuation

Let’s have a look at the dividend discount model. I’m assuming a discount rate of 7.8% for both the DDM and the DCF model.

BAT shares dividend discount model

The BAT share price today stands at 27 British pound, so the gap between Fair Value and the current share price seems to be ludicrous. Hence why I’m always double checking with the Discounted Cash Flow method ๐Ÿ‘‡

DCF valuation

Let’s include straightaway some scenario analysis for this one. It allows us to include the risk of British American Tobacco not being able to gain appropriate market share in the US for it’s Glo brand.

ScenarioFCF Growth assumptionFair Value
Losing revenue due to missing boat in the US-6% FCF next 5 years17,74
Late in the game, but slowly gaining market shareFlat FCF next 5 years27,95
Just on time, still enough growth to be gobbled up6% growth in FCF next 5 years40,72
fair value estimate bat shares
FCF calculation

This gives us 3 options: either the stock is currently 52% overvalued, around fair value or 33% undervalued. I leave it up to you which scenario to choose.

The company itself seems to be optimistic, because it’s still targeting a mid-single growth for this year and it’s optimistic for the upcoming years.

If they’re right, then today would’ve been a great opportunity to buy BAT shares at 27 pounds and a dividend yield of 7.4%.

Final thoughts and conclusion about owning BAT shares

I found it very interesting to analyze British American Tobacco. It always feels good to me to discover new stocks which might generate wealth for the next few decades.

Honestly, I’m strongly considering to initiate a position at these prices. I believe that the market is overreacting on the impact that the company might have from the FDA approval for its competitor iQOS ($PM).

I have one issue though. My wife doesn’t allow me to purchase stocks in this company, because in her opinion “tobacco companies don’t add value to society”.

I will try few more times and share her my opinion about sin-stocks. But as we’re in it together, I will respect her opinion which in such case will prevent me from becoming a shareholder in British American Tobacco.


What do you think? Do you own shares in British American Tobacco? Do you find this company interesting?

Let me know what you think about it in the comment section below ๐Ÿ‘‡

Yours Truly

European Dividend Growth Investor

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5 comments on “British American Tobacco – Will it help you in building a better tomorrow?

  1. Very good analysis! I have been shareholder of BAT for some years and always reinvested the dividends. The tobacco industry as a whole and BAT in particular have their challenges (BAT is still โ€ždigestingโ€œ the very expensive Reynolds acquisition, which led to high leverage). The current valuation looks attractive and I wouldnโ€™t be surprised to see BAT shareholders handsomely for many years.
    Cheers

    • European DGI

      Thanks for stopping by MyFinancialShape ๐Ÿ™

      Yep, it was expensive. I got less concerned after looking at the interest coverage and the debt/equity ratio. They seem to be able to consume the debt pretty well.

  2. Phil S.

    I am in the same situation and not sure if I want to engage in this market. Definitely check out news like this: BATS does more than smelly smoky stuff: https://www.bat.com/group/sites/UK__9D9KCY.nsf/vwPagesWebLive/DOBNHBWR (link is weird, if it does not work, check out “Potential COVID-19 vaccine โ€“ BAT in the news”

    Regarding the risk assessment vs. potential return:
    What I currently do is estimating what Dividend-YoC I could expect in 10 years from this stock. With the numbers from your post: 7.4% DivYield and an average DivGrowth of 5.82%, we get ~12% YoC_10y. Cumulating 10 years of dividend payment, we have a return of ~96%. Sure, never say never, but can the tobacco industry really collapse that much in 10 years?
    Just to compare: If we assume a ~3.5% YoC that we might have had during BATS highest value in 2017 (just an assumption, not based on actual data). 10-years accumulated dividends would have been ~45%. Not much room for big declines that we could expect with this industry and its perception in the public / health concerns.

    • European DGI

      Hi Phil,

      I am with you, I really think that this is one of those value-plays that others will later say about: I wish I bought more at the time ๐Ÿ˜‰

      96% is indeed really a lot!

      Thanks for stopping by.

  3. Hi EuroDGI,
    I am always a bit leery of stocks that have lost over 40% compared to 40% gain of S&P over past three years. Over the past 10 years dividend growth has been a bit spotty compared to previous 10 years. I also share your wifeโ€™s concern:-) Cheers.

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