British American Tobacco: Yielding 9.63% Like An Opportunity Than A Value Trap (BTI)

The previous 12 months haven’t been kind to British American Tobacco (NYSE:BTI) as shares have declined -14.91%, and it’s been an even worse decade as shares have fallen -46.46%. The tobacco industry continuously finds itself under pressure as it’s synonymous with health risks and government regulations. Despite individual opinions, the facts are that BTI has exceeded $10 billion in operating income and free cash flow (FCF) on an annualized basis since 2018 while generating large single-digit dividend yields. When I look at BTI from a business perspective, it looks tremendously undervalued, and I have recently added it to my position. Just like Altria Group (MO), I feel the perception of BTI’s business and not its actual operational performance is the reason why shares have not caught a bid. While technology controls the narrative and has fueled the rally, I think the broad market will catch up over the next year, and BTI will be looked back on as an opportunity that got away rather than continuing to be a value trap. I will continue adding to my position at these prices and happily sit back and collect the dividends while I wait for my investment thesis to unfold.

Following up on my previous article about British American Tobacco

I haven’t written about BTI in some time, as my last article was published on July 19^th, 2021 (can be read here). Since then, shares of BTI have declined by -20.83% compared to the S&P 500 appreciating by 20.98%. I have been incorrect so far, and Mr. Market has other plans for shares of BTI. Not even the large dividend yield has been able to make shareholders whole. When the dividends are factored in, BTI has a total return of -3.75% as a tremendous amount of value has eroded from shares over the past 2 ½ years. In that article, I discussed BTI’s business and why I felt its profitability would lead to a better valuation and a larger dividend. Well, I have been incorrect about the better valuation, and while the dividend has grown, BTI hasn’t been a good investment. I am following up with a new article to discuss why I am still bullish on BTI and feel shares have bottomed.

Risks to my investment thesis in BTI

BTI isn’t an investment for individuals who don’t have a high tolerance for risk. The tobacco industry has been scrutinized for decades as the companies within the sector have to continuously adapt to evolving regulations. The latest from the U.S. Food and Drug Administration is that they are proposing to ban menthol-flavored cigarettes in the U.S. BTI faces risks from legislative authorities as health concerns continue to paint a negative stigma and drive changes to existing laws. There has been a significant opportunity cost as a standard S&P 500 index fund has outperformed BTI over the past 5-years, and there is no technology narrative around A.I. or cloud computing that can stimulate investor enthusiasm. BTI faces operational risks from the global economy as well as its competitors. If we endure unfavorable tobacco harvesting conditions, then BTI could face a reduced supply and a decrease in the availability of tobacco. As we move to a smokeless industry, BTI can also face enhanced competition as Altria Group and Philip Morris (PM) allocate billions toward oral tobacco and heated tobacco products rather than combustible.

Breaking down why I am bullish on BTI regardless of the negative stigma on tobacco

Several people have asked me how I can invest in tobacco companies. Tobacco has been around for centuries, and tobacco products are legal despite the correlation to health conditions. I am looking at the business from a profitability standpoint, and until tobacco products are deemed illegal, I have no issues investing in them if I feel there is a potential upside to allocating capital. Currently, I am viewing BTI as a value play rather than a value trap and feel there is a significant opportunity in its shares on a forward-looking basis. Anyone can look at the chart and see that shares have been down almost 50% over the past decade, but it’s not about where shares came from; it’s about where they are today and where they have the potential to go. This reminds me a lot of the MLP industry as shares plummeted for many companies, such as Energy Transfer (ET) and Enterprise Products Partners (EPD), from 2014 – 2016 when the price of oil rapidly declined, then again after the pandemic started. While a fuel transition narrative continued to be painted, investors who started positions in ET and EPD during 2021 have generated significant income from the distributions and capital appreciation. I think BTI is in a similar situation, and the fundamentals are too strong for shares to trade at this low valuation.

Starting with the balance sheet, BTI has a strong foundation under its operating businesses. BTI has $5.94 billion in cash on hand, with another $766.2 million in trading asset securities. BTI has another $2.66 billion in long-term investments, which brings the liquidity on its balance sheet to $9.37 billion. This is 20.86% of the $44.91 billion in long-term debt on its balance sheet. BTI has $151.34 billion in total assets and $67.01 billion in total liabilities, which brings the company’s equity to $67.48 billion. BTI also has a book value of $29.08, which is a solid foundation for its share price of $30.32, which doesn’t trade at that large of a premium.

From an operating standpoint, BTI is running an extremely profitable enterprise. After BTI acquired the remaining 57.8% of Reynolds American Inc. in 2017, its revenue and profitability significantly increased. While the revenue and profitability has been stagnant, BTI is producing tens of billions in both categories. In 2022, BAT generated $33.43 billion in revenue, and its revenue cost was $5.81 billion. This left BTI with a gross profit of $27.62 billion and a gross profit margin of 82.63%. BTI operates at the same levels as SaaS companies, and quite honestly, if this was a SaaS company, I would bet the valuation would be much different. BTI produced $14.96 billion in EBITDA, which is a margin of 44.75%. BTI’s FCF came in at $11.93 billion for a margin of 35.69%, and its net income after all taxes and interest payments was $8.28 billion for a profit margin of 24.67%.

In 2023, BTI grew every category except its net income due to the impact of the non-cash impairment charge taken mainly against their acquired U.S. brands. This is why I look at both net income and FCF because FCF isn’t impacted by GAAP Accounting principles as much as net income, it’s simply cash in minus cash out. BTI grew its revenue by 4.01% to $34.78 billion YoY. Its gross profit came in at $28.55 billion, which was an increase of $921.8 million (3.34% YoY). This placed BTI at an 82.07% gross profit margin, and they generated $16.92 billion in EBITDA and $13.07 billion in FCF. BTI took a charge of -$21.75 billion and had an -$3.66 billion income tax expense in 2023, causing its net income to be -$18.09 billion. This is an anomaly due to the impairment, and looking at the operating income for 2023, which came in at $16.11 billion, BTI is running like a well-oiled machine.

It’s not often that you can purchase a company at 6.44 times earnings, but in BTI’s case, this is the reality. The market is deeply discounting its profitability due to the industry in which it operates in. This can either be a red flag or an opportunity, and I see this as an opportunity to acquire shares of an extremely profitable company for a low valuation. BTI is currently trading at 6.44 times its 2024 earnings and 5.8 times its 2026 earnings. Over the next 2 years, BTI is expected to grow its EPS by 11.04%. While BTI looks undervalued on this metric alone, it trades at a cheaper valuation compared to its peers of Altria Group and Philip Morris. Altria trades at 8.55 times 2024 earnings, while Philip Morris trades at 14.41 times 2024 earnings. I also looked at their price to FCF to see how many years it would take for these companies to generate their entire market cap in FCF. BTI is trading at 5.19 times its current FCF, while Altria trades at 8.48 times and Phillip Morris trades at 18.11 times. Regardless of the industry that BTI is operating in, this cash cow generates billions upon billions in profits and is even discounted compared to its peers.

BTI is gearing up for a big capital allocation plan for shareholders

In addition to generating large profits, BTI pays a dividend of $2.92, which is currently a yield of 9.63%. BTI has established a 20-year track record of progressive dividend growth, and after the Reynolds American Inc. acquisition in 2017, BTI changed its payment frequency to quarterly rather than bi-annually. In 2023, BTI paid $6.52 billion in dividends to shareholders, which was only 49.87% of the FCF that was generated. There is a lot of room for management to continue increasing the dividend while finding other ways to reward shareholders.

On the Q4 conference call, management indicated that they ended the year at 2.6 times adjusted net debt to adjusted EBITDA, which is closer to the middle of their target range of 2-3 times. Management also disclosed that once the middle of its target range is reached, they will evaluate additional options to return excess cash to shareholders, including discussing the introduction of a sustainable buyback plan. BTI is projecting that it will generate $43 billion in FCF before dividends in the next 5-years. If BTI increases the dividend by 2% on an annual basis, it will pay out around $34.61 billion in dividends over the next 5-years, and it would still have around $8.4 billion in FCF left. They could easily grow the dividend by 2% on an annual basis and buy back $1 billion worth of shares annually while utilizing the remaining FCF to grow their business.

Conclusion

The tobacco industry has seen better days, but it’s still an extremely profitable endeavor for industry leaders. If you can look past the industry, BTI looks like an opportunity at today’s levels rather than a value trap. BTI is paying a dividend of 9.63% and trades for 6.44 times its 2024 earnings. In 2023, BTI generated $13.07 billion in FCF, which places its price at 5.19x. The major risk is that regulations continue to evolve and make doing business harder for tobacco companies. I am willing to accept that risk as tobacco companies have been adapting to changing regulations for decades and are still generating billions in profits. BTI looks extremely undervalued by traditional standards, and when I compare them to their peers, I see that they trade at a discounted valuation. I feel there is an opportunity to lock in a 9.63% yield on cost at today’s levels and that there is potential for capital appreciation on the horizon with BTI. They are putting their capital to work, and if they are able to implement a buyback program, its forward EPS should increase, and I think it will become an investment opportunity that many will not ignore. I am long BTI and adding to my position.