Investment Thesis
British American Tobacco (NYSE: BTI) is a leading, multi-category consumer goods company best known for their tobacco products. They have been a leader in the tobacco industry for several decades, and their top selling brands include Pall Mall, Kent, Dunhill, and Lucky Strike. Contrary to the public perception that the tobacco industry is dying, the market is actually stable with a growth rate of 3-4% per year. Thanks to negative perception and regulatory barriers, existing tobacco giants enjoy a robust economic moat that won't be breached any time soon. British American Tobacco is one of these giants. They show strong profitability and cash flow, and are a great option for the dividend investor because:
- The overall tobacco market is growing, and British American's product initiatives should ensure stable future prospects. I expect them to continue to generate lots of cash going forward.
- Profitability of British American Tobacco is off the chart. All metrics show the strength of their economic moat.
- Even with the recent rise in stock price, they remain undervalued. PE is low relative to competitors.
Overall tobacco industry growth and British American's initiatives
Remembering all those past lawsuits against tobacco companies and seeing "No Smoking" signs everywhere, the general public have the idea that the tobacco industry is dying. However, this is not true. The global tobacco market is valued at $730 B in 2020, and it is expected to grow at a rate of 3.78% until 2026. While it certainly is not a fast growing industry or a darling of Wall Street, the industry is still quite stable with modest growth.
Poor public perception actually helps existing companies in the industry. There are no aspiring young entrepreneurs seeking to develop new products, as is ubiquitous in the tech or biotech sectors. Also, a myriad of regulatory hurdles doesn't really help new entrants either. This means that current existing giants like British American Tobacco can enjoy their big chunk of the pie without worrying about industry disruption. Currently, British American Tobacco holds 12% market share (#1 amongst publicly traded companies and tied with Phillip Morris International) in the global cigarette market, and this market distribution should stay stationary for a long time.
The low possibility of new entrants means that there is little need for capital expenditure ($712 M on 2021) or R&D expenses (not showing on income statement). Given a revenue of $34 B, capital expenditure of $712 M is rather minimal, especially for a company that actually manufactures and sells physical goods. The low spending in these areas mean high cash flow for the company as a whole. Cash from operations increased from $7.1 B in 2012 to $13 B in 2021. I expect this healthy cash flow to be sustained in the foreseeable future.
To sustain revenue growth, British Tobacco has been introducing new product lines, and the initiative has been going very well so far. New category revenue has been growing at 32% CAGR since 2018, and revenue for non-combustible products has been growing at 31%. All three new categories (Vuse in Vapor, glo in Tobacco Heating, and VELO in Modern Oral) are performing well within their respective markets, which bodes well for British American Tobacco in the future. I expect them to maintain their market share.
Strong economic moat shown by profitability metrics
Thanks to the attributes mentioned above, British American Tobacco has a substantial economic moat around their business. Government regulatory barriers is one of the main hurdles for new competitors, and the established companies have plenty of experience navigating these. British American Tobacco's strong economic moat shows up in their profitability metrics. Their gross margin (82%), EBIT margin (42%), and Net Income margin (26%) are several times higher than sector medians. Customers are certainly paying a premium to use their products.
Given British Tobacco's various initiatives to increase their revenue and market share, which have been very successful, I expect their economic moat to stay substantial for the foreseeable future. Also, the low requirement for capital expenditure and R&D won't change anytime soon. Therefore, I expect their free cash flow margin to stay well above the sector median for long time.
Still undervalued by the market
In the past several months, the market has been volatile and there has been a strong current of investors transferring money from risky assets to safer ones. Thanks to this trend, stock price of British American Tobacco has risen substantially from $33 in December 2021 to $45 now. Yet even with this recent substantial advancement, they are still undervalued compared to peers.
Looking at the P/E ratio (TTM), British American's P/E is at 11x, whereas Philip Morris' is at 18x and Altria's is at 38x. Comparing P/S ratio (TTM), British American's at 2.95x, Altria's at 4.5x, and Philip Morris' at 5.22x. Therefore, I believe the British American Tobacco is still undervalued, and there is substantial margin of error for the investor. I expect their stock price to rise to match their peers in the future.
Intrinsic Value Estimation
I used the DCF model to estimate the intrinsic value of British American Tobacco. For the estimation, I utilized operating cash flow ($13,140 M) and the current WACC of 8.0% as the discount rate. For the base case, I assumed operating cash flow growth of 2% (lower end of expected industry growth rate) for the next 5 years and zero growth afterward (zero terminal growth). For the bullish and very bullish case, I assumed operating cash flow growth of 3% and 4%, respectively for the next 5 years and zero growth afterward. As the overall industry is expected to grow at a 3-4% rate for the foreseeable future, and British American Tobacco is a leader in the business, a growth rate of 3-4% is very achievable.
The estimation revealed that the current stock price represents 30-35% upside. Given the strong economic moat of British American Tobacco, and their new growth initiatives, I expect they will achieve this upside. Also, this estimation further strengthens the argument that the stock is undervalued at this point.
Price Target Upside Base Case Bullish Case Very Bullish Case
$59.25 31% $61.64 36% $64.13 42%
The assumptions and data used for the price target estimation are summarized below:
- WACC: 8.0%
- Operating Cash Flow Growth Rate: 2% (Base Case), 3% (Bullish Case), 4% (Very Bullish Case)
- Current Operating Cash Flow: $13,140 M
- Current Stock Price: $45.18 (02/25/2022)
- Tax rate: 30%
Risks
Due to the negative sentiment surrounding the tobacco industry and bad public relations in the past, large institutions are not really interested in investing in companies like British American Tobacco. The current institutional ownership stands at 6.5%, and this number is unlikely to increase. Without big block purchases from institutions, stock price typically doesn't appreciate substantially over the short term. Perhaps this explains the current undervaluation. Therefore, it may take a long time for British American's stock price to appreciate towards its intrinsic value.
Companies in the tobacco industry have large exposure to changes in government regulations. Any policy changes regarding products related to tobacco can substantially decrease the sales of British American Tobacco and sour the company's future outlook. New product lines from tobacco companies are always under heavy scrutiny from the government and health organizations, and this poses risks to the company. Therefore, the investor should always pay close attention to any (upcoming) regulatory changes in the industry.
Conclusion
Existing tobacco giants enjoy a substantial economic moat, and their superb profitability and market share will stay in place for a long time. Stable growth prospects for the overall industry and new product initiatives will preserve British American Tobacco's future revenue. Thanks to their strong profitability and cash generation ability, British American Tobacco will keep rewarding investors with a high dividend (currently at 6.5%). I expect 30-35% upside along with the juicy dividend yield going forward.
Cappuccino Finance
I believe in fundamental analysis and disciplined market research. I have strong quant background with a Ph.D. (Chemical Engineering, University of California, Santa Barbara) in model predictive control and an MBA (Jones School of Business, Rice University). My primary focus is to identify 1) small cap companies with strong fundamentals and growth potential, 2) large cap companies going through temporary set-backs, and 3) stable companies with solid dividend yields and growth potential.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BTI either through stock ownership, options, or other derivatives. 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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