Since the middle of 2017, shares in British American Tobacco have fallen by as much as 30%. The shares now have a dividend yield of almost 5%, so does this mean they’re good value?
British American Tobacco: A brief overview
British American Tobacco is the world’s leading tobacco and “next generation product” business.
It sells combustible tobacco and nicotine-related products (e.g. Rothmans cigarettes) to millions of people in dozens of countries along with a growing range of next generation products, otherwise known as “potentially reduced-risk” products (e.g. vype).
Companies that sell cigarettes are usually quite defensive (i.e. non-cyclical), because smokers are unlikely to quit or even cut back on their smoking just because there’s a recession.
On top of that there is an incredible amount of brand loyalty among cigarette smokers as most smokers stick to a single brand for years or even decades. That helps to keep BAT’s revenues and profits stable from one year to the next which makes it even more defensive.
On the negative side (at least from BAT’s point of view), the number of cigarettes sold across the world has been falling in recent years and that trend is expected to continue over the long-term.
Ever-tighter regulation and a general desire not to die of lung cancer are driving this decline in traditional tobacco products. That’s why BAT’s potentially lower risk, non-combustible products are so important for its future.
So at first glance it seems as if British American Tobacco is a stable, defensive business operating in a declining market. Investors are probably afraid that BAT could enter a long and slow decline and that could be why its dividend yield is close to 5%.
Growth rate: A mixed bag with dividend growth and revenue decline
Here’s a chart showing British American Tobacco’s headline financial performance over the last few years:
As you can see, the dividend has been increasing at a healthy rate (about 6% per year) along with earnings per shares (about 7% per year).
Unfortunately the picture is not so rosy for revenues, which have been shrinking for much of the past decade. This is clear evidence of the decline in cigarette sales globally.
The jumps in revenues, earnings and dividends in 2017 are a result of BAT’s acquisition of Reynolds America, a £42 billion acquisition which made BAT the largest publicly-traded tobacco company in the world.
I’ll have more to say about that acquisition later, but for now I’ll just say that the gains in 2017 are one-off in nature and are unlikely to be repeated unless the company makes further large acquisitions.
Overall, BAT’s growth rate over the last decade has averaged 4.9% per year, which is slightly above the FTSE 100’s combined earnings and dividend growth rate of 3.2%.
Growth quality: Above average, which is to be expected
As a defensive company it’s reasonable to expect BAT to increase its revenues, earnings and dividends more consistently than other companies, and it has.
BAT’s growth quality score (which measures how often revenues, earnings and dividends have increased over the last decade) is 83% compared to 63% for the FTSE 100.
As with high growth companies, stable companies also typically command premium share prices because investors are willing to accept lower returns in exchange for lower risks (for example, higher share prices lead to lower dividend yields which may result in lower returns).
This doesn’t seem to apply to BAT though, perhaps partly because of fears about its shrinking market but also because many investors refuse to invest in tobacco companies.
Profitability: Above average, but about to decline
Profitability is an important metric as it can be an indicator of competitive strength.
There are lots of different profitability ratios, but I like ten-year average return on capital employed (ROCE), partly because it gives you an idea of the sort of returns a company might make on retained earnings, i.e. those it doesn’t pay out as a dividend.
BAT’s ten-year average ROCE is 20%, exactly double the average for stocks on my stock screen.
In other words, and very simplistically, you might reasonably expect BAT to generate a 20% annual return from any fixed or working capital it owns, such as factories, machinery or inventory.
However, this high ROCE ratio has just collapsed in 2017, thanks to the Reynolds acquisition:
This acquisition, which cost £42 billion in cash and shares, was for the 58% of Reynolds which BAT didn’t yet own (so it already held a 42% stake in the company).
Now that Reynolds is 100% owned by British American Tobacco, Reynolds’ results and balance sheet must now be fully incorporated into BAT’s financial statements.
As a result of the acquisition, BAT’s intangible assets have jumped by more than £100 billion to £118 billion.
This vast intangible asset represents the “goodwill” paid for Reynolds and other previously acquired companies, above and beyond the value of their tangible assets (such as factories, machinery and inventory).
Is it reasonable to pay £100 billion more than the value of the acquired companies’ physical assets?
Possibly, but only if the companies can generate returns from their physical assets which are far above average.
However, by paying such a high price to acquire Reynolds, it’s likely that BAT will achieve a rate of return on that investment far below the 20% or so it could have gotten by investing directly in new factories, machinery and inventory.
So there’s a trade-off. Buying Reynolds gives BAT instant scale in the US and a collection of mature brands. But buying Reynolds will also give much lower returns than if BAT had built up its position in the US by organic expansion rather than acquisition.
Or to put it another way, BAT has chosen rapid but lower return growth through acquisition rather than slower but higher return growth through organic expansion.
I have no idea which is the best route for BAT, but as a general rule I am not a fan of large acquisitions.
Debt: High, thanks to the Reynolds acquisition
Another thing I’m not a fan of is high debts, especially when they’re taken on in order to acquire other companies.
Unfortunately, that is exactly what BAT has done.
The Reynolds acquisition has pushed BAT’s total borrowings up from around £20 billion to almost £50 billion.
That takes BAT’s debt ratio (the ratio of total borrowings to five-year average post-tax profits) from 4.8 to 10.7.
Generally I won’t invest in companies where the debt ratio is above five. BAT’s ratio is more than double that, which is not good.
Having said that, this picture is distorted by the fact that the additional borrowings are on the balance sheet but the earnings from the acquired Reynolds business are not yet on the income statement.
It seems likely that BAT’s profits will grow once the profits from Reynolds come through in full, but I doubt they’ll increase by enough to bring BAT’s debt ratio back down to “prudent” levels anytime soon.
The company itself admits that it is now overleveraged and intends to delever significantly by 2019. We shall see if it can meet that intention.
Capex: Not much required in the way of capital investment
One of the attractive features of tobacco companies (from an investor’s point of view anyway) was the lack of capital assets required to churn out vast numbers of cigarettes and vast profits.
In essence, all BAT needs to do is buy some specialised cigarette-making machines, put them in a factory and leave them to churn out millions of cigarettes every year.
Because the cigarette industry is not particularly competitive (i.e. profit margins and returns on capital are generally quite high) each machine is able to generate a lot of profit relative to the upfront cost of the machine.
This shows up in British American Tobacco’s consistently high return on capital, but it also shows up as consistently low capital investment relative to profits:
On average, most companies spend an amount equal to about two-thirds of their profits on the maintenance or expansion of capital assets. BAT’s average figure is 18% and this sort of low capex requirement is a useful feature to have because it makes expansion relatively cheap and easy, if and when the company is able to expand.
Is British American Tobacco investible?
Let’s summarise the story so far:
On the positive side of things, BAT is a defensive company, it has a long history of steady growth and it pays a regular progressive dividend.
It’s also geographically diverse, highly profitable and is the largest publicly traded company in its industry.
On the negative side, the company operates in a market which may be in long-term decline and it is exposed to significant regulatory risk, i.e. the risk that regulation will continue to tighten, making its products more and more expensive and less and less attractive to the next generation of potential smokers.
The company has also taken on lots of debt in order to fund the acquisition of Reynolds America, which in my opinion was probably done in order to offset BAT’s declining revenues.
However, growth (or the avoidance of decline) by acquisition is a risky strategy because:
- it often involves the use of large amounts of debt,
- acquired companies typically increase the complexity of the acquirer and also need integration and
- can result in low returns for investors if the price paid for the acquired company was too high.
Leaving the question of price to one side, my position on BAT is mixed:
On the one hand, I am already a BAT shareholder and BAT is a holding in my defensive value portfolio. I am happy to hold BAT because I think there’s a reasonable chance it can continue to grow for the next decade or more.
It could achieve this through a mix of cost cutting, share buybacks and more acquisitions, as well as increasing market share.
On the other hand, if I wasn’t already a BAT shareholder I would probably not invest in the company at the moment, regardless of price.
The high levels of debt and the recent mega-acquisition of Reynolds would be enough to put me off because of the increased levels of risk they bring to the company. There are plenty of other fish in the sea and I would probably just look elsewhere.
So that’s my view of the company; now it’s time to look at the share price:
My target “buy” and “sell” prices for British American Tobacco
BAT has an above average growth rate, above average growth quality and above average profitability. In short, it has been an above average performer and my assumption is that it will continue to be for at least the next few years.
This means I think BAT should command a premium price relative to the market average.
By “premium price” I mean BAT’s price relative to its past earnings and dividends should be above the market average, which means its dividend yield should probably be below average.
So what do we have today?
BAT currently has a share price of 4,000p and the FTSE 100 is at 7,200, giving BAT a:
- PE10 ratio (price to 10-year average earnings) of 19 (FTSE 100 = 16.5)
- PD10 ratio (price to 10-year average dividend) of 28 (FTSE 100 = 32)
- Dividend yield of 4.9% (FTSE 100 = 4.0%)
BAT’s PE10 and PD10 ratios are higher than the FTSE 100’s, but only very slightly. This suggests the market is giving BAT only a very small quality premium.
But BAT’s high dividend yield tells a different story. It’s comfortably higher than the index’s, which is what you’d expect to see from a value stock rather than a premium stock.
Overall, I think it’s clear that British American Tobacco shares are not trading at the sort of premium price I would expect to see from a company with its track record of relatively consistent growth.
Unilever, for example, has a similar track record to BAT but only has a dividend yield of 3.2%.
From my point of view, this is a good thing. I think BAT has a reasonable chance of producing decent growth over the next decade, so to me its shares appear to be undervalued.
At 4,000p, BAT sits at 28th place on my stock screen out of more than 200 dividend-paying stocks. That’s another reason why I continue to hold BAT.
As a general rule I only buy stocks that are in the top 50 on that screen, so if I was looking to buy BAT in the next few months (which, as I mentioned above, I’m not) then that rule would give me the following price target:
- Target buy price: I would only consider buying BAT below 5,000p
At 5,000p BAT would still have an above average dividend yield of 3.9%, so I think that price would still be reasonably attractive, assuming I wasn’t bothered about the high debts and large acquisition.
At the other end of the scale, I tend to look for the exit when a stock’s rank on my screen falls below 100. That’s about halfway down my stock screen and, for context, the FTSE 100 currently sits at position 135.
Since I am a BAT shareholder the target sell price is more relevant to me, and here it is:
- Target sell price: I would seriously consider selling BAT above 7,000p
At 7,000p BAT would have a dividend yield of just 2.8% which is below average. Its PE10 ratio would also be above 30, and that’s generally the point at which I begin to think a company, even a quality company, could be overvalued.
As an existing shareholder I am happy to hold British American Tobacco for now. The dividend yield is good and the company may be able to offset the effect of its shrinking market for many years to come.
There are of course risks, not only those shrinking markets, but regulatory risks as well, not to mention the high debts and recent very large acquisition. In fact those debt and acquisition risks are so high that if I wasn’t a shareholder already, I wouldn’t buy BAT today.