2023-06-09 11:00:48 ET
Summary
- British American Tobacco stock has disappointed investors as it continued a steep slide from its highs in November 2022.
- The company's decision not to launch a new stock buyback program could have worried investors about whether its shares are really undervalued.
- However, the company's recent trading updates suggest it continues to do well in its reduced-risk products. Its legacy segment is also expected to recover.
- BTI's price action is also more constructive, with dip buyers returning over the past two weeks to defend against a further selloff.
British American Tobacco (BTI) has likely disappointed its holders since BTI topped out in November 2022. I anticipated buyers returning to support the pullback in January , but it has not panned out well.
Accordingly, BTI has significantly underperformed the S&P 500 ( SPX ) ( SPY ), as BTI re-tested lows last seen in October 2020. As such, I'm not surprised that weak holders could have been driven to throw in the towel and rotate out, despite its attractive valuation.
I believe the main buy thesis undergirding BTI at the current levels is undoubtedly its valuation. Seeking Alpha Quant rated an "A+" (best possible) valuation grade for BTI. Moreover, its forward dividend yield of 8.3% is well above its 10Y average of 5.8%.
However, despite the highly appealing valuation, buyers have failed to return robustly, as selling pressure overwhelmed BTI over the past seven months. An attempted recovery in February 2023 was "torpedoed" as the company decided " not to launch a new share buyback program."
Panmure Gordon analysts shared their concerns then, suggesting it was "at best strange, at worst disconcerting." Why so? I think I can try to simplify the logic of stock buyback, leveraging the wisdom of Warren Buffett from Berkshire Hathaway's ( BRK.A ) ( BRK.B ) recent annual meeting in May.
Buffett reminded investors that " the decision to repurchase shares can be the dumbest or smartest thing, depending on the circumstances." He also stressed that "if the stock price is above intrinsic value, it's a no-brainer not to do a share repurchase program." However, he also articulated the "importance of growing the present business and making decisions on dividends before considering share buybacks."
As such, I believe that the optics of not buying back more BTI shares in the open market likely sent the wrong signal to BTI holders that its share was not considered "undervalued." Moreover, Morningstar applauded management's previous program, as it " created value because the shares were purchased at levels well below [its] fair value estimate."
However, I think the right way to think about the current situation is that BTI needs to be judicious about allocating capital in the current macro environment. Makes sense?
BTI is entering arguably the most transformative phase in its business as it attempts to reach £5 billion in revenue for its reduced risks segment by 2025. However, that segment delivered only £2.9 billion in revenue last year. As such, the company likely needs to allocate capital aggressively to invest in the segment to ensure it remains on track. And there's no guarantee of success, as the competition is intense.
Altria Group's ( MO ) purchase of NJoy attempts to reshape the market dynamics with Altria's extensive distribution network. Moreover, Philip Morris's ( PM ) re-entry with iQOS must be carefully watched. Hence, I believe while BTI's dividend safety is likely not in imminent danger (rated "C-" by Seeking Alpha Quant), the company needs to be cautious, given the continued need to invest and scale its reduced-risk segment.
Therefore, I'm assured that BTI has continued to see improvement in its reduced-risk products, as the company reported recently that " Vuse value share increased by 2.8 percentage points, reaching 38.8% in key vapor markets."
Moreover, its legacy tobacco segment is also seeing notable improvement, particularly in the premium segment. BTI noted sequential growth in its premium volume share "since the beginning of the year."
Notwithstanding, the company must still navigate the secular decline in tobacco products while coping with near-term headwinds in the discount segment. As such, I assessed that market operators were justified to reflect a wider margin of safety against BTI's valuation to account for these challenges.
However, the question is whether these headwinds have been sufficiently accounted for in BTI's current levels, allowing dip buyers an opportunity to return and try "catch the falling knives?"
With the steep selloff from BTI's November highs, I assessed that BTI had reached well-oversold conditions, allowing for a lower-risk entry point for dip buyers.
Notably, I also gleaned that buying sentiments have improved over the past two weeks, corroborated by the release of the company's trading update this week.
Therefore, given the steep selloff, I believe the risk/reward profile of buying the dips at the current levels is attractive relative to BTI's risk/reward profile.
Coupled with possibly less perilous macroeconomic headwinds moving ahead, a potentially sharp mean-reversion opportunity to the BTI's critical moving averages is increasingly possible.
So, it's time to catch the falling knives. As a note, I gleaned similar technical signals in Warner Bros. Discovery ( WBD ) stock in a late May article . Accordingly, WBD has significantly outperformed the SPX over the past two weeks, notching a gain of more than 26% compared to the SPX's 3.4% uptick. Its valuation then was also an "A+," if that rings a bell.
Rating: Buy
Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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British American Tobacco: Yes, It's Time To Catch The Falling Knives