British American Tobacco (NYSE: BTI) is a leading multi-category consumer goods company, known for its tobacco products. They have been a leader in the tobacco industry for several decades and their top selling brands are Pall Mall, Kent, Dunhill and Lucky Strike. Contrary to 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 solid economic gap that won’t be bridged 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 global tobacco market is growing and British American’s product initiatives should ensure a stable future outlook. I expect them to continue to generate plenty of cash in the future.
- The profitability of British American Tobacco is not there. All measures show the strength of their economic gap.
- Even with the recent rise in stock prices, they remain undervalued. PE is low compared to competitors.
Global Tobacco Industry Growth and British American Initiatives
Remembering all those past lawsuits against tobacco companies and seeing “No Smoking” signs everywhere, the general public gets the idea that the tobacco industry is dying. However, this is not true. The global tobacco market is valued at $730 billion in 2020, and it is expected to grow at a rate of 3.78% through 2026. While it is certainly not a fast growing industry or From a Wall Street darling, the industry is still fairly stable with modest growth.
Poor public perception actually helps existing businesses in the industry. There are no budding young entrepreneurs looking to develop new products, as is ubiquitous in the tech or biotech industries. Plus, a myriad of regulatory hurdles don’t really help new entrants either. This means that current existing giants like British American Tobacco can enjoy their big slice of the pie without worrying about industry disruption. Currently, British American Tobacco has a 12% market share (#1 among publicly traded companies and tied with Phillip Morris International) in the global cigarette market, and this market share is expected to remain flat for a long time.
The low possibility of new entrants means that there is little need for capital expenditure ($712m in 2021) or R&D expenditure (not appearing on the income statement). Considering revenue of $34B, the capital expenditures of $712M are pretty minimal, especially for a company that actually manufactures and sells physical goods. Low spending in these areas means high cash flow for the business as a whole. Operating cash has grown from $7.1 billion in 2012 to $13 billion in 2021. I expect this healthy cash flow to continue for the foreseeable future.
To support revenue growth, British Tobacco has launched new product lines, and the initiative has gone very well so far. Revenue from new categories increased by 32% CAGR since 2018, and revenue from non-combustible products increased by 31%. The three new categories (Vuse in Vapor, glo in Tobacco Heating and VELO in Modern Oral) are doing well in their respective markets, which bodes well for British American Tobacco in the future. I expect them to maintain their market share.
Strong economic swing illustrated by profitability measures
Thanks to the attributes mentioned above, British American Tobacco has a significant economic moat around its business. Government regulatory barriers are one of the main hurdles for new competitors, and established companies have plenty of experience in overcoming them. British American Tobacco’s strong economic moat is evident in its profitability indicators. Their gross margin (82%), EBIT margin (42%) and net profit margin (26%) are several times higher than industry medians. Customers certainly pay a premium to use their products.
Given British Tobacco’s various initiatives to increase revenue and market share, which have been successful, I expect their economic moat to remain substantial for the foreseeable future. Moreover, the low need for capital expenditure and R&D will not change anytime soon. Therefore, I expect their free cash flow margin to stay well above the industry median for a long time.
Still undervalued by the market
Over the past few months, the market has been volatile and there has been a strong flow of investors moving money from risky assets to safer ones. Thanks to this trend, British American Tobacco’s share price has risen significantly from $33 in December 2021 to $45 now. Yet even with this recent substantial advance, they are still undervalued compared to their peers.
Regarding the P/E ratio (TTM), British American’s P/E is at 11x, while that of Philip Morris is at 18x and that of Altria at 38x. Comparing the P/S ratio (TTM), British American at 2.95x, Altria at 4.5x and Philip Morris at 5.22x. Therefore, I believe British American Tobacco is still undervalued and there is a substantial margin of error for the investor. I expect their stock price to rise to match their peers in the future.
Estimation of intrinsic value
I used the DCF model to estimate the intrinsic value of British American Tobacco. For the estimate, I used operating cash flow ($13,140M) and the current WACC of 8.0% as the discount rate. For the base case, I assumed operating cash flow growth of 2% (low end of expected industry growth rate) for the next 5 years and zero growth thereafter (terminal growth nothing). 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 thereafter. As the industry as a whole is expected to grow at a rate of 3-4% for the foreseeable future and British American Tobacco is a leader in the industry, a growth rate of 3-4% is quite achievable.
The estimate revealed that the current share price represents an upside of 30-35%. Given British American Tobacco’s wide economic moat and its new growth initiatives, I expect it to achieve this rise. Moreover, this estimate further strengthens the argument that the stock is currently undervalued.
Very bullish case
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 million
- Current stock price: $45.18 (02/25/2022)
- Tax rate: 30%
Due to negative sentiment surrounding the tobacco industry and poor public relations in the past, big institutions aren’t really interested in investing in companies like British American Tobacco. Current institutional ownership stands at 6.5%, and that number is unlikely to increase. Without large block purchases by institutions, stock prices generally do not appreciate substantially in the short term. This may explain the current undervaluation. Therefore, it may take a long time for the British American stock price to appreciate towards its intrinsic value.
Companies in the tobacco industry are highly exposed to changes in government regulations. Any change in policy regarding tobacco-related products can significantly reduce British American Tobacco’s sales and affect the company’s future prospects. New product lines from tobacco companies always come under scrutiny from government and health organizations, posing risks to the company. Therefore, the investor should always pay close attention to any (upcoming) regulatory changes in the sector.
The existing tobacco giants enjoy a substantial economic gap, and their superb profitability and market share will remain in place for a long time. Stable industry-wide growth prospects and new product initiatives will safeguard British American Tobacco’s future revenues. Thanks to its strong profitability and ability to generate cash, British American Tobacco will continue to reward investors with a high dividend (currently at 6.5%). I expect 30-35% upside with a juicy dividend yield going forward.