Let’s look through a different lens based on hard facts and data rather than perception: over the past 30 years, Altria (MO) and British American Tobacco (BTI) have delivered approximately 17% and 13% compound annual growth, respectively. This time period was “cherry picked” to include the full breadth of the gigantic settlement that put an albatross around the neck of U.S. tobacco companies to the tune of hundreds of billions of dollars.
Past performance isn’t indicative of future returns is at the bottom of every investment-related marketing brochure. We understand its purpose but this is a more accurate version:
Past performance is indicative of future returns only to the extent (“i”) the historical drivers of the individual company, sector, and overall market performance are separated, thoroughly understood, and re-evaluated, then (“ii”) measured against projections for the future, and (“iii”) adjusted for the reliability of the projections and evaluation of past stock performance.
We’ll come up with something more eloquent one day but that gets the point across. British American Tobacco has outperformed the S&P 500 by over 500 basis points annualized since inception. As discussed in our “Heavily Discounted Tobacco Stocks” series, this is result of an interesting mathematical phenomenon.
Most stocks tend to trade at “fair” valuations over the long run. Firms that grow cash flows at high rates than average to trade at high equity multiples and pay low cash yields and vice versa. For tobacco, social influences, socially responsible investing (“SRI”) at major institutions, and a general disdain for tobacco companies have caused the segment to trade at valuations that are disproportionately low for their growth rates.
What does this result in? Investors continuously reinvest above-average distributions into below average cost (in terms of valuation) shares. Since tobacco stocks have generated significant growth over time, the compounding effect is magnified to the point they’ve outperformed all other sectors over the last 20/30/40 years.
Stated differently, stocks are nothing more than cash flow machines with price tags relative to their long-term expected money production. That applies equally to stocks that pay distributions and those that do not. Tobacco stocks have been heavily discounted for so long, investors were able to reinvest their cash flow generation to buy more cash flow machines (in this case shares) than they could using cash flow machines in other sectors.
This phenomenon is also why certain REITs (e.g. Realty Income (O)) and BDCs (e.g. Main Street Capital (MAIN)) have produced among the highest total return in the S&P 500. The market priced them incorrectly for their growth rates and risk for long periods of time, permitting investors to reinvest ever-increasing cash distributions into additional shares that subsequently generate even more cash available for further reinvestment. It doesn’t take that long, say eight to 10 years, for this situation to result in truly massive gains.
With the stage set, let’s move on to British American Tobacco.
As you review any major tobacco company’s financials and prospects, we believe there are a few key themes to consider in modern times.
First, the decline in the company’s core combustible products (e.g. cigarettes) should be carefully evaluated, modeled, and compared to its peers. Second, the firm’s recent and historical mergers and acquisitions (“M&A”) track record should bear the same scrutiny. Tobacco companies are notoriously active in the M&A space and good or bad deals can make or break the firm’s earnings. Third, the plans associated with offsetting the decline in combustible products must be run through the same process.
Williams Equity Research (“WER”) maintains a dedicated framework for evaluating every major sector we cover including each type of REIT, BDCs, MLPs, and most types of C-corp dividend stocks (e.g. automotive, bank, integrated oil and gas, tobacco, et cetera).
The other elements of the analysis, such as securitizing recent and expected cash flows, the balance sheet, corporate governance, and changes in the management team or operational footprint are approximately the same as any other established company.
BTI’s Full-Year 2019 Results & Strategic Goals
BTI’s management is aware of the framework analysts use (at least decent ones) to evaluate their company and that’s reflected in their reporting.
Source: BTI Capital Markets Day 2020
Amusingly, we didn’t reference the above presentation until after writing the previous section but it mirrors the order of what we listed. Before we evaluate year-to-date 2020, let’s understand how the firm performed in 2019.
Source: BTI Capital Markets Day 2020
Management cherry-picked a couple of these, as we’d expect, but the results are better than expected given the challenges the industry has faced in recent quarters. Remember that people in much of North America and Europe were unable to visit many of the stores they usually purchase BTI’s products.
Primarily through disciplined cost management, BTI increased earnings per share (“EPS”) by 8.4% over the period using constant currency exchange rates. Revenue didn’t grow as much but was a positive 5.6%. Perhaps most notably, combustible revenue growth, an industry in a structural decline throughout most of the globe, saw 4.6% growth. Margins were also up albeit only slightly. Remember, BTI trades at only 10.5x trailing earnings. If the firm can manage high single digit EPS growth, it’s set up for very strong returns over the medium and long-term.
Source: BTI Capital Markets Day 2020
Not unlike many other U.S. and European companies, BTI is squarely on the “socially responsible” bandwagon despite the reality of its core business. This shapes its new product development and capital allocations going forward. This includes becoming “carbon neutral” by 2030 and obtaining 50 million non-combustible consumers on the same timeline. I’m not particularly interested or concerned in the firm’s carbon footprint (assuming they aren’t penalized), but we like their ambitious new category customer target.
BTI’s 2020 Performance YTD
2020 has certainly been an interesting year and one with characteristics that usually bode well (at least for the companies selling them) for alcohol and tobacco consumption. Our familiarity with the long-term performance of major equity sectors through various crises led to our high-conviction recommendation of Philip Morris International (PM), Altria Group, and Constellation Brands (STZ) in March and April. All three are now incorporated into our Institutional Income Plus model portfolio though the allocation to STZ was reduced when it hit our initial return target of 50%.
Source: BTI 2020 First Half Financial Release
Starting at the top-line, revenue increased 0.8% in the first half of 2020 compared to the same period in 2019. IFRS profit margins rose 16.4% over the same period to a highly impressive 41.5%. Strong margins are the source to tobacco’s incredible historical cash flow generation and they remained intact for 2020.
Operating margins rose 5.5% resulting in a 22.7% increase in diluted EPS. There are very few multinationals that can match that statistic outside of a few technology stocks, most of which were simply at the right place at the right time in our opinion. BTI also provides “adjusted” metrics which back-out one-time events and other items considered to have a temporary impact on the company. These results are also generally strong but not to the extent of the IFRS figures (as a reminder, IFRS is the international accounting standard used by foreign firms instead of U.S. GAAP). Adjusted EPS was still up almost 7% in constant currency. Overall, both in terms of revenue, margins, and profits, BTI has had a very strong 2020 in absolute terms and relative to 2019. BTI managed to achieve its 2020 guidance established before the crisis.
Let’s touch on a few of the key items cited previously. Non-combustible categories represented 10% of total revenues in the first half of 2020. The firm invested £250 million in new categories marking over the period. As a standalone figure, that doesn’t tell us much. For better context, we calculate the £250 million spent in new product marketing is 2.0% of the period’s total revenues and 20% of the revenue generated specifically from the non-combustible division. This means that BTI is reinvesting approximately 20% of non-combustible revenues back into that division. That’s a figure we are comfortable with.
Many companies lack discipline and will divert precious resources from healthy divisions to keep lackluster ones afloat. Ford’s (F) stubbornness of pouring good money after bad in the Chinese and European markets comes to mind. BTI’s marketing appears to be effective with new categories revenue growth of 12.7% over the period. Where BTI has invested the most, like Vapour and THP, growth is even stronger at +71% in volume share. BTI is taking a sustainable and logical approach to its capital allocations.
Source: BTI 2020 First Half Financial Release
Cigarette volumes were down 6.3% over the period which is approximately in line with industry averages. Note the relative strength of the U.S. market compared to the other regions which saw much higher declines in volumes despite BTI garnering market share in most. Modern oral nicotine products saw immense growth as did the newer Vapour category.
As an interesting statistic, BTI still sold 315,000,000,000 (315 billion) individual cigarette’s in the first half of 2020. Given we already mentioned that total revenue for this segment was actually up, it’s clear that pricing power must have more than offset that; that’s indeed the case at +8.5%.
BTI Dividend Analysis
Tobacco companies are legendary for their consistent cash distributions, but we take nothing for granted. BTI follows the dividend policy we strongly prefer and often find associated with European nations: fixed percentage dividend payout ratio rather than fixed amount. Some U.S. stocks, like Ruger (RGR), follow the same philosophy. This, by definition, makes the dividend sustainable long-term as long as positive earnings are generated.
BTI’s forward dividend is $2.71 per share annually resulting in a current yield of 7.43%. The dividend payout ratio is in line with management’s stated objectives. We’ll put that yield into context in our Valuation & Conclusion section.
In recent quarters, the distribution payout ratio has been +/-5% of the targeted payout ratio.
BTI Balance Sheet Durability
BTI was active in the credit markets thus far in 2020 despite market volatility. The firm refinanced the existing £6 billion on the revolving credit facility with attractive terms and raised $2.4 billion and £1.7 billion in April as well as another £500 million in June (international firms raise debt in multiple currencies depending on where the best value is at the time). Separate from this, BTI arranged short-term financing facilities totaling £4.8 billion in response to the uncertainty associated with the crisis. £1.2 billion of that has been tapped as of June 30th.
Adjusted net debt ended Q2 at £44.2 billion compared to free cash flow generation and revenue of £2.4 billion and £12.3 billion for the first half of 2020. BTI’s maturity schedule is favorably constructed with only 5% of net debt due in the next 12 months. Debt has been falling 1-2% quarterly in line with management’s goals. Leverage ratios, while reasonable, are one area that separates BTI from its higher quality peers like Philip Morris.
Interest expense, listed as “net finance cost” in BTI’s financial reports, was £786 million in the first half of 2020 or a reasonable 15.4% of operating profit. That’s low enough to pose no material risk to the firm but high enough that management can improve profitability by reducing it over time.
BTI is rated at Baa2 by Moody’s. Below is what we consider the most useful of their commentary.
British American Tobacco’s Baa2 rating is underpinned by its strong market position as the largest tobacco company in the world by net revenues, its broad geographical diversification, solid brand portfolio and significant pricing power. The Baa2 rating also takes into consideration the company’s stable EBITDA and cash flow generation and improving debt metrics, albeit still weak for the rating category.
The rating also reflects the secular decline in traditional tobacco sales, a generally adverse regulation environment affecting the tobacco industry, the relatively higher exposure of BAT to litigation risk compared to peers and a still modest revenue contribution from potentially reduced risk products.
Moody’s ranks Philip Morris and Altria Group A2 and A3, respectfully. Here’s a reminder of what that means.
While Philip Morris and Altria are rated several notches higher than British American Tobacco, we don’t see a downgrade in the near future and very low risk of the firm losing its investment-grade rating in the near or medium-term as long as it doesn’t pull a “JUUL-like” acquisition stunt.
Valuation & Conclusion
BTI’s management estimates that the coronavirus will have a net headwind to adjusted revenue of approximately 3%. That’s a simple yet powerful testament to the durability of the business model. The last financial filing notes the following as further evidence.
Capital expenditure and investment plans have been, to date, largely unaffected by COVID-19.
That said, the same business model’s core cash flow generate is in decline. There is a reason most of management’s focus and marketing materials are focused on the new product lines; 88-90% of current earnings are still produced by traditional combustible sales, such as cigarettes. BTI and the other major tobacco companies are walking a tightrope in order to shift their businesses’ cash flow derivation from these new categories before the cigarette “golden goose” goes dry. It’s unrealistic to assume these firms can indefinitely raise prices to offset volume declines, even though they’ve done exactly that thus far.
Given how incredibly stable big tobacco earnings have been, even in the context of the coronavirus crisis, their price-to-earnings ratios are unusually useful valuation tools. For BTI in particular, its fixed percentage dividend payout ratio means the yield is also an easy way to reliably ascertain value. In fact, the output is mathematically identical outside of the small variation in payout ratios.
BTI’s dividend yield is near its highest levels in the last 32 years.
Using trailing twelve-month data, BTI trades at 10.5x EPS compared to 9.0x and 14.9x for Altria and Philip Morris, respectively. The reasoning behind the dispersion is too detailed to cover completely here, but suffice to say that the market strongly prefers Philip Morris as the best tobacco company and is severely discounting Altria for its very costly investment in JUUL. Imperial Brands (OTCQX:IMBBY) is another large tobacco company we’ve discussed at length and trades at 16.0x the past twelve months’ earnings. That’s only part of the story, however, once cash yields are taken into account (as of 9/29/2020).
Imperial Brands: 13.25%
Altria Group, Inc.: 8.83%
British American Tobacco: 7.43%
Philip Morris International: 6.30%
Combining the valuation and yield data, Altria Group appears the best value, all other things equal. Despite our major concerns, and frankly irritation, with the firm’s M&A activity, that’s why it maintains a place in our model portfolio available to subscribers. British Tobacco isn’t as high quality in terms of management or its balance sheet as Philip Morris, but it’s undoubtedly attractive at current levels.
Our target buy range for BTI is reserved for subscribers but is only modestly below current levels. We are targeting a 40% total return in the next 12-24 months depending on how the broader equity markets perform. We reserve our proprietary risk ratings for subscribers, but we rank British American Tobacco one notch higher (worse) than Philip Morris as an indication of its relative standing.
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Disclosure: I am/we are long STZ, MO, PM, F, O, MAIN. 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.