BTAFF - British American Tobacco: Solid Income And Capital Appreciation Potential

2024-01-20 03:28:30 ET

Summary

• British American Tobacco has seen a decline in share price, leading to a high dividend yield of approximately 10%.
• The company's financials suggest that the dividend is sustainable and there is potential for continuous modest dividend growth.
• BTI offers significant capital appreciation potential, with a target price of US$42.57 per share, implying 45% upside.

High dividend yields should be approached with caution. Sometimes, it's the case that the business of a particular company has taken a downturn and it can't sustain paying the same dividend as before. As a result, the share price usually drops in anticipation of that, but the high yield lags behind as previous payments are used in its calculation. However, there are exceptions to this - companies, with sound business performance, who have taken a hit on negative investor sentiment, but are more than able to sustain and even raise their dividend. In this article I'll lay out why I think British American Tobacco ( BTI ) to be such company and why the current levels may be a great entry point.

Operational overview

While BTI is yet to release its 2023 full-year results (based on history I expect this to be done in the first half of February), the December update indicates organic YoY revenue growth of about 3%. The H1'23 results, which are the most recent, given the semi-annual reporting of BTI indicate that it diversification strategy is slowly working as new categories revenue continues to grow rapidly.

At the same time, the decline in combustibles revenue in the main market - the US is more than offset by AME and APMEA, as the increase in disposable income in most emerging markets still translates into higher demand for tobacco. As such, on a Group level, the core business recorded 0.2% YoY growth in H1'23.

Deleveraging on the way

On the balance sheet, BATS had around GBP42.2B of debt as of H1'23, down from GBP44.9B a year earlier. However, after accounting for cash and equivalents, the figure drops to GBP37.3B of net debt (-6.3% YoY). Management has shifted focus on deleveraging as no share buybacks were carried in 2023. In terms of maturity, the bonds seem adequately spread out in time as there's no year with more than GBP3.5B of securities maturing. Such figures are easily coverable by the free cash flow, which amounted to GBP$8B in 2022.

The dividend is sustainable

Such figures indicate that the dividend is well-covered and there's no reason to expect dividend cuts. On the contrary, the company has been consistently raising its dividend in recent years. It has a 2.46% dividend CAGR for the last 5 years in USD terms. However, in GBP terms the increase has been 3.41%. Based on those trends and the company's results, dividend towards 59.69p (US$0.76) per quarter could be expected in 2024. The exact amount will most likely be revealed when full-year 2023 results are released in February.

Valuation discussion

British American Tobacco has been in a downtrend since its peak in February 2022 with the latest big blow being dealt in December, when US$31.5B of write downs were announced . However, this is a non-cash event, so it won't affect in any way the ability of the company to keep making distributions back to shareholders. I'll value the company using two methods - the Gordon Growth Model of the DDM approach and peers comparison.

Gordon Growth model

As the company is a mature regular dividend payer, the Gordon Growth model seems appropriate valuation approach.

I'm basing my assumptions on historical data. The average payout ratio of the company for recent years has been around 75%. However, it recently fell considerably below that figure in the last period, hence I'll adjust it to 70%, implying 30% retention ratio. I'm assuming ROE of 10%, a little higher than the 5-year average of 9.62%, but lower than the most recent one of 11.71%. This results in implied growth rate of 3% (g=b*ROE).

*Data from Seeking Alpha; Damodaran; Author's own calculations

I calculated the required rate of return, using the CAPM. The US 10-year bond is used as a proxy for the risk free-rate, while unlevered beta for the tobacco sector and ERP figures are taken from Damodaran's database . Subsequently, I levered the beta in order to reflect BTI's balance sheet and used the average effective tax rate for the last 5-years of 25% in the process.

Assuming annual dividend payout of US$3.04 (equivalent to US$0.76/quarter), growth rate of 3% and required rate of return of 11.3%, I get fair value per share of US$36.49, implying 24.3% upside to the current price of US$29.36.

Peers comparison

* Data from Seeking Alpha

For peers comparison, I used the median TTM P/E and TTM EV/EBITDA values, derived from a group of 6 tobacco stocks. Subsequently, I weighted each ratio by 50%, which resulted in a fair value per share of BTI of US$48.64, implying 65.7% upside from the current price.

Target price

My final target price is derived by assigning 50% weighting to each valuation approach. The final figure is US$42.57 per share, offering 45% upside from current levels. According to these calculations and the dividend sustainability analysis, BTI seems to poses both solid income characteristics (dividend yield of approximately 10%) and capital appreciation potential.

Risks

The biggest risk to BTI as well as the tobacco industry as a whole is regulation. For example in 2022 New Zealand moved to impose a ban for individuals born after a certain year to ever buy cigarettes, aiming to create a "smoking-free" generation. The measures included additional restrictions limiting the places, which sell tobacco products and so on. However, in 2023 the new government abandoned this plan, as it would've costed the budget a much-needed revenue. The UK is also moving towards banning cigarette sales to individuals born in 2009 and thereafter. Other developed nations may follow suit with similar measures, theoretically curbing BTI's combustibles business.

The company is trying to mitigate this risk to an extend by advancing other categories. But on a macro level, history shows that such prohibitions simply don't work. One has to look no further than the National Prohibition of alcohol in the US in the 1920s, which was a failure and was subsequently scrapped to see that such policies simply don't work.

Conclusion

British American Tobacco's business intact and keeps growing at a low single digit percentage. At the same time, the share price has fallen considerably, raising the dividend yield to approximately 10%. The financials of the company seem to back-up the dividend amount and continuous modest dividend growth could be expected. At the same time, due to the decline in share price, BTI seems to offer significant capital appreciation potential. My calculations, using an equal weighted peers comparison and GGM approach indicate a target price of US$42.57/share, implying 45% upside.

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