British American Tobacco: 15%-24% Annualized Potential Upside

There’s a popular quote out there from Cullen Roche that goes something like this:

“The stock market is the only market where things go on sale and all the customers run out of the store.”

The meaning here is that when the stocks you’ve been waiting to buy get a big discount from the market, you won’t want to pick them off the shelf and head to the counter.

Why?

Because there’s always something going on that will deter you from buying. It could be war, plague, or famine – whatever the case, it doesn’t matter. Put simply, there are always good reasons to sell stocks.

Today, we’ve got a classic case of narrative panic, combined with an unbelievable deal in a well-known global company; British American Tobacco (NYSE:BTI).

When we wrote about the company last September, we emphasized a number of the company’s strengths:

• BTI’s addictive product
• BTI’s healthy dividend
• BTI’s attractive valuation

All of these things remain in play, but the bad news has kept piling up.

Recently, to cap off a year of heartache for BTI investors, shareholders were notified that the company had just taken a £25 billion impairment, essentially writing down the value of the company’s U.S. based combustible brands (like Camel and Newport) to zero by 2053.

This caused yet another 9% selloff in BTI shares that resulted in the stock ending the year on a sour note:

However, despite being down 26% in 2023, the company’s financials appear sound, the dividend appears well backed, and BTI stock appears to be one of the best deals on the market today.

Today, we’ll break down our bull thesis for the company and explain why we think there is significant potential upside for investors in BTI from now into the foreseeable future.

Without further ado, let’s jump in.

The Next Big Oil?

The dominant narrative out right now about BTI (and other tobacco giants like Altria (MO) and Philip Morris (PM)) is that the industry is in secular decline.

‘People just aren’t buying cigarettes like they used to’, the thinking goes, and numerous recent legislative pushes across the globe have appeared to threaten the very future of the industry.

In New Zealand, for example, the health ministry has pushed to have smoking banned for anyone born following 2008, which would effectively nix the country’s consumption of combustibles over time.

Malaysia has followed suit, attempting to ban cig consumption for people born after 2007, and Rishi Sunak in the UK has also moved to turn the policy into law.

This recent spate of anti-tobacco legislation is more activist in nature than the majority of global policy around the industry today, which simply takes a high-tax stance on the consumer side around combustible products.

One is tempted to draw parallels to another industry that to some is also morally questionable and has drawn political ire in the past: big oil. As renewable energy surged in popularity in the years leading up to 2020, especially among politicians, you’d often hear people talking about the long-term secular decline of oil as an energy resource.

As a result, the energy sector lagged the S&P 500 massively throughout the latter 2010’s due to persistent negative sentiment and a generally unfavorable supply / demand environment for the black commodity:

However, despite the deep branding issue and genuine problems that surround the industry and its poor environmental track record, the sector turned around and spanked the S&P 500 from 2021 onwards in terms of performance, following the re-opening supply shortage and subsequent energy price inflation:

As it turns out, we still need the oil industry.

A similar exhaustion is currently affecting anti-combustible movements globally. New Zealand and Malaysia have recently pulled back on their plans to ban combustibles, claiming that the policy would too severely damage tax revenue.

Additionally, Rishi Sunak’s plan to remove combustibles from circulation appears stalled, without much in the way of popular opinion from MP’s.

As it turns out, we still need the tobacco industry.

BTI’s Financials

For its part, BTI has weathered this political storm well from a financial standpoint.

Aside from the stock performing poorly and the company writing down the terminal value of its U.S. combustible brands as mentioned, things appear stable and growing.

TTM gross profit just hit an all-time high, and the company is raking in record net profits from the sales of its products:

As we’ve claimed before, selling a cheap, addictive product is one heck of a business model.

The U.S. impairment largely looks to be based around the genuine decline in demand for combustibles over time among the U.S. population, something that isn’t seen everywhere. Between the U.S. preference headwinds and the political drag, it’s easy to see how investors up to this point have felt nervous about the industry’s future.

But take a step back, and everything appears fine. EPS is even forecasted to grow in the coming years:

It’s also expected that BTI’s reduced-risk portfolio will begin to take up some of the slack introduced by BTI’s exposure to the U.S. combustibles market, with CEO Jack Bowles saying the following on the recent conference call:

We continue to work hard to engage with regulators around the world, to help inform them of the science that supports the potential benefits of smokers switching to reduced risk products. New Categories already represent a significant percentage of the revenue and growth in a number of archetypes, and we expect these archetypes to be dynamic, over time.

This coincides with the fact that BTI’s reduced risk brands are already profitable, and should help the company maintain a 4% long term EPS growth rate, especially as they continue to grow and gain economies of scale.

All in all, despite the noise surrounding the impairment, BTI is still poised to grow over the long term due to continued global demand for combustibles, strong pricing power, and new growth from pouches, vapes, etc.

The Unbelievable Valuation

We expect that as this negative narrative surrounding the tobacco industry abates, the sector – and BTI specifically – will once again re-rate towards multiples that are more historically in line, which means a big opportunity for investors right now.

As it stands, if you overlay BTI’s current price vs. the current potential fair value of the business, you can see that the company is cheap, cheap, cheap:

The graph here is plotting BTI’s best fit P/E line of the last decade plus, which shows ‘fair value’ potentially sitting around 13x earnings. Alternatively, you can apply a potential fair value for BTI’s projected earnings at around 15x, which is in line with GDF pricing.

But what is the upside here, if the stock comes back into line? Let’s look at two scenarios: a ‘bearish’ case and a ‘bullish’ case.

In a conservative case, let’s assume that BTI continues along its long-term growth rate (which analysts have been incredibly accurate at predicting) of about 4%.

By 2028, and using a highly discounted valuation, BTI shares stand to produce 14% annualized returns over the interim:

Here’s what a $10,000 investment would return over that period of time:

That’s pretty attractive, considering that it’s almost our ‘worst case’ scenario.

In a more aggressive scenario, let’s say that narrative headwinds abate and produce multiple expansion over time. In that scenario, if P/E expands back to 12x, (which is still a discount vs. BTI’s long term multiple), then you’re looking at a ~24% annualized rate of return over the interim:

This also appears attractive, especially vs. an S&P 500 which looks rather expensive at the moment.

Again, recall that we haven’t targeted an ‘aggressive’ valuation here, or margin expansion even to the long term mean. Even conservative estimates produce a highly attractive RoR here, which is what has us so excited.

Risks

The main risk here is that continued multiple compression happens as a result of narrative weakness or a material lack of growth in the results.

That could lend more credence to a ‘terminal decline’ thesis, which would likely not see BTI’s EPS valued at even our bear case’s 7.5x.

That said, this appears highly unlikely due to the advantages we’ve mentioned before, and thus, in our mind, our concerns are ameliorated to a large degree.

It’s still something to keep in mind, although hopefully as earnings report after earnings report continues to show growth, we expect the market’s broad fears to change.

Summary

BTI is incredibly well priced considering median estimates are expecting the company to grow, and the company retains a strong business model as a global CPG brand with multiple avenues of growth and pricing power.

Because of that, and when including the dividend, even BTI’s bear case appears attractive for investors at the current juncture in our view.

We rate BTI a “Strong Buy”.

Cheers!