Complete Devastation, Massive Income With British American Tobacco (NYSE:BTI)

Our investing approach is one that blends growth, income, and value, along with targeted trading in beaten-down names primed for a rebound. Sometimes, a high-yield is a red flag. Other times, quality companies can be in an unfavored sector, and see their stocks get creamed, driving a sustainable dividend-paying company into the high-yield range. We focus on finding the best income names to round out our trading, ones where we can collect a solid dividend while we also wait for a turnaround in share prices. We believe British American Tobacco (NYSE:BTI) fits the bill. We began buying in the low $30s, scaling into an income position on the way down. In the short-term, a few months to a few quarters, we do not stress about price action. Think about it like a rental property you might own, collecting rental income. Do you get the house appraised every week? Of course not, so it should be with a name you buy for income and capital appreciation. Quarterly is fine, checking in on the 10-Qs, and changes to holdings and/or the regulatory environment.

Make no mistake, shares have been crushed. Investors? They have been left devastated. We believe there has been a ‘kitchen-sink’ of news priced into BTI stock here. Years of revenue pressures, complicated regulatory pressure, challenges breaking into new markets, introducing new products, and a debt burden that persists. The ‘kitchen-sink’ moment really came a few weeks ago. Back in December when British American Tobacco completely revalued some U.S. cigarette brands. This was a massive accounting move to make up got the fact that management did not see the brands continuing to have $80 billion in value on the balance sheet. As such the company reported a $31.5 billion non-cash adjusting impairment charge. Moreover, the company will amortize the remaining value of its U.S. combustibles brands in 2024. This was a massive shakeup.

This news follows ongoing battles with public health regulators pushing more taxation on tobacco purchases, pushing to raise smoking ages, and moving away from combustible tobacco into smokeless technologies. Even on the smokeless end, regulators have not stopped, with the World Health Organization pushing for a complete ban on flavored vaping products. To say it is a time of transition for British American Tobacco and the industry is an understatement. But with these pressures, there has been uncertainty, and uncertainty has led to the Street selling down the name quarter after quarter. At these levels, we are stepping up and buying the juicy near 10% yield, and looking for a turnaround. We think there is a positive risk-reward setup for income investors, and those looking for a rebound.

The long-term chart leaves something to be desired. It has been an orderly selloff since the start of 2022. Do you know what that coincides with? It is when the rate hiking campaign from the Fed began. In fact, when we were shorting the REIT space, it was for similar reasons, seeing rate hikes as creating massive competition for income names, with the added pressure on the costs of borrowing. While it was not completely universal, many income names took it on the chin, as yield seekers moved assets into more low-risk bonds, money markets, even cash. But we are on the precipice of rate cuts this year, and thus we believe we will start to see more of a push into income names, as investors reassess the risk-rewards. With British American Tobacco, you can soak up the dividends it rains down, and collect a near 10% yield to wait.

As we look ahead to earnings that will be reported in a few months, we do note that there is sales growth here. Despite all of the chaos, we expect full-year 2023 revenue growth. However, the writedowns among other pressures will lead to revenue coming at the lower end of British American Tobacco’s previously guided 3% to 5% range (controlling for currency). As we move ahead for the next few years, we see the company’s investments into new nicotine delivery technologies as pushing the company’s revenue growth by 5% each year, and mid-single-digit profit growth of 3-7% each year. The company will continue to invest in the non-combustible product sector here in 2024, and suspects it can push to 50% market share. This is a strong outlook.

Meanwhile, this push will come as British American Tobacco moves away from traditional cigarettes. Each year you can expect more and more revenues to move away from combustibles to new categories. Take for example vapor liquids. The company’s Vuse product continues to take share reaching close to 37% value share in key markets, and rising each year. From our review of the financials and earnings, Vuse continues to deliver strong revenue growth, driven by more customers and pricing power. More adult smokers are switching to Vapor than any other new category, with Vapor and Heated Products equally effective at encouraging smokers to switch. While it is a debate among public health professionals, there is evidence that vaping is less harmful than smoking, though we would certainly not argue that it is not ‘bad for you.’ Of course, other industries are the same, alcohol, gambling, fast food, processed and frozen goods, etc.

As we look to performance, we expect revenue growth and free cash flow growth to be in the low single digits for the next 5 years. This comes as the company moves to be a smokeless tobacco company. There are many macroeconomic headwinds impacting the U.S. combustibles industry. New categories are growing. For example, in the Modern Oral segment, Velo continues to deliver strong volume-led revenue growth and increasing profitability. The company’s volume share of the Total Oral category in key markets is up 110bps in 2023, reaching 8.5%. Velo continues to perform well and is a category leader in Europe with a 67% volume share.

When the company does report full-year results in February, we expect to see that the global tobacco industry volume is expected to be down 3%, but with the low single-digit revenue growth aforementioned, and ongoing cost-control efforts we expect 4-5% adjusted EPS growth which also factors in revaluation adjustments for the U.S. brands and the divesting out of Russia in fall 2023.

As we look at valuation, an EV/EBITDA of 6.7x is historically low. While this may of course reflect the market’s uncertainty of the transition away from combustibles and into a ‘smokeless’ company, this level is attractive from historical trading trends. We are also looking at 6X FWD earnings and a sub 5X price-to-free cash flow. These are all well below the five-year averages for the company.

So, the company is in transition but forecasting growth. It is raining dividends here:

Now, dividend growth-type investors will shun this history, but the income is very healthy, and the flexibility in the dividend keeps it more secure than forcing a consistent or growing dividend. But is the dividend secure? Well, we cannot rule out a few cents of change, but the payouts will continue based on the key safety metrics. First, the payout ratio is around 50%. This is one metric we look at for the other income names that we recommend to our investing group. A simple, but key metric. British American Tobacco’s short-term debt & capital lease obligations as of the half-year report in 2023 were $6.350 billion, while long-term debt was about $46.9 billion. Considering that annualized EBITDA was about $17.1 billion, it suggests there is significant leverage here. The debt-to-EBITDA ratio was 3.1X, though it is moving into the mid-2-3X range as a goal. In the recent transcript from mid-2023:

Over the next five years this business is on track to generate £40bn of free cash flow before dividends, with cash conversion in excess of 90% and leverage moving towards the middle of our 2 to 3 times net debt to EBITDA corridor.

This is still significant leverage, but with interest of around 4.3% on its debt (as mentioned in the call linked above), this is well below market rates. With rate cuts in the future, future refinancing will be at much lower rates than what new debt could be acquired today. However, the debt burden does remain a risk.

Take home

We have a near-10% yield here, and we are buying. While the debt and leverage are a risk, and you have to contend with ongoing regulatory issues, the transition to ‘smokeless’ is leading to market share gains, revenue growth, and improved cash flow. We see the potential for upside in shares for traders and are happy to be collecting the raining dividends for income while we wait.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.