British American Tobacco: Largely Immune To AI; A Smoking Good Deal (BTI)

What does AI have to do with a tobacco company? Well, a lot actually. Artificial intelligence has taken the investing landscape by storm since ChatGPT was launched last November. Investors have been preoccupied with AI concepts; busy investigating how AI will advantage some companies and threaten others.

Consumer staple stocks, including British American Tobacco p.l.c. (NYSE:BTI) have been one of the casualties thus far. Momentum has been on the side of tech stocks, particularly the semiconductors which stand to benefit from increased demand for hardware used to create AI systems. Money chases gains which has resulted in incredible concentration in a few names. Apple (AAPL), Microsoft (MSFT), NVIDIA (NVDA), Alphabet (GOOG), and Meta (META) have accounted for over 80% of the S&P 500’s gain year to date.

And this was before NVDA’s incredible rise following their latest earnings release. The company raised its guidance for revenue next quarter by $4 billion and the stock gained $360 billion in market cap within hours in after-market trading. All the while, BTI investors have watched the price of their shares fall by 13% over the last month. The momentum towards tech is sucking liquidity out of defensive sectors right at the time that we think it’s wise to be overweight defensive.

The neglect by the market has created the most attractive period to buy BTI stock in years, based on valuation. There are many dangers in the market as a result of AI maturation, but investors are not looking for these risks in all the right places.

AI Immunity

Put simply, BTI has immunity from AI because the company earns its revenues from the sale of tobacco and related consumer products. AI technology will have negligible effects on the market because the technology cannot replace the product that BTI offers. It’s possible that AI can be used to improve the manufacturing and marketing of tobacco products but large tobacco companies like BTI would largely benefit from such advancements because the industry is so difficult to enter for new competition. There are business operations processes that could benefit from AI technology, which we would expect to be a net positive for the company.

But there is a larger implication. While investors should be wary of the negative effects of AI that undermine a company’s competitive advantage, we think the more pressing risk comes from overconfidence in companies with perceived AI advantage. Take NVDA, again. While the growth in revenues has thus far been impressive, shares are wildly overpriced in our opinion. The forward price to sales ratio for NVDA is now 31.12. Do investors acknowledge that this implies it would take 31 years to earn back their investment with 100% of current revenues distributed to shareholders? It’s a heavy lift.

Using NVDA’s normal price to sales ratio of 6.31x as a measure of fair valuation, the company would need to increase revenues by 30% every year for the next 7 years for the current price to reach fair valuation. The potential growth is already priced in and then some. We think it’s safe to say that there is no margin of safety at these prices.

Where there is a margin of safety is in a consumer staple stock like BTI which has been ignored by the market because it offers no such AI appeal. Compared to the high PS ratios of tech megacaps, BTI sports a P/S ratio of 2.12. Granted, company revenues are not growing strongly and are subject to decline depending on several influencing factors. Analysts are expecting revenues to increase by 11.8% over the next three years. Through its history, BTI has increased revenues by 3.91% CAGR. Its largest declines in revenues were 13% in 2015 and 12% in 2005.

The risks that investors under-appreciate is the risk of overpaying for hyped names in the AI space. Even if growth expectations are met, it is probable that future has already been priced in. And if growth fails to materialize, it could be devastating. We’ve witnessed this kind of behavior before. The internet boom that caused the Dotcom crash saw many names trade up and down like a rocket. Cisco was one such name that traded as high as 36x price to sales ratio before crashing 90%. We’re not implying that NVDA is destined for that fate, the illustration urges caution.

Smoking Good Valuation

BTI is a large cap value stock and the second largest tobacco company in the world. It should be expected, then, that we are attracted to the value shares offer. The company has operations in 180 countries and the majority of its revenue comes from outside of the U.S. This is a disadvantage when the U.S. dollar is strong, such as it is now, but offers geopolitical diversification for their products which faces significant political headwinds. The Fed tightening cycle has helped to support the dollar. While we do not have a dollar index forecast, it seems that the monetary tightening cycle is nearing an end. Soon a new monetary easing cycle will begin which we expect will remove support for the dollar.

BTI is now trading at historically low valuations. The adjusted operating earnings yield for the company is now 14.24%. This is nearly half of its long-term normal yield of 7.5%. However, since 2018 the market has assigned a lower valuation to the company as a result of the evolution of risk over the past few years.

The normal price multiple since then has been 8.45x. Even compared to this normal multiple shares are undervalued. If shares were to trade back to this normal multiple and earnings estimates hold true, shares are expected to return 23% CAGR through 2025.

BTI also trades at a near all-time low price to book value of 0.797. The all-time low is 0.757. BTI has experienced growth in equity per share since 2019 of 10%. This has been the result of flat asset growth but a decrease in debt. The company’s debt to equity ratio is around 0.58 and debt to capital ratio is 0.34 which are both respectable. The company has cash obligations of £5.7 billion within 1 year, £9.0 billion in 1-3 years, and £7.2 billion in 3-5 years. BTI earned $14.6 billion in EBIT in 2022 and EBIT is expected to grow by 12% in 2023. They also had $4.8 billion in cash at the end of 2022.

Seeking Alpha gives BTI superb scores for valuation and profitability, and those are the features that we find attractive. Growth is considered mediocre and we find that acceptable as long as expectations and estimates for growth are mostly accurate. In 2022, the company’s revenues increased YoY by 2.3% on a constant currency basis but grew in reported revenues by 7.7%. Its new product categories are demonstrating robust growth with the segment reporting growth of 40.9% YoY. Even combustibles, its largest segment and the most vulnerable to changing market conditions and regulation, grew by 4.5% reported but declined by 0.6% on constant currency [CC]. U.S. revenues declined in 2022 by 2.8% YoY CC while most other jurisdictions grew in revenue.

ITC Limited & Dividends

We want to conclude by drawing attention to BTI’s interest in ITC Limited. ITC Ltd is an Indian conglomerate company which markets tobacco products, as well as paper and packaging, agri-business, branded apparel, personal care goods, and hotel services. As of December 31, 2022, BTI owned 29.19% of ITC Ltd worth £12 billion or about $14.4 billion USD. ITC has been performing exceedingly well over the past few years including a 32% rise in 2023. We estimate this position is now worth ~$19.3 billion USD which is 23% of BTI market cap or $7.57 per share.

One of the most attractive features of BTI is the dividend they offer. BTI has a current dividend yield of 8.55% at a payout ratio of 40.6%. The dividend yield isn’t the highest on record but it’s very close.

Forward dividend estimates expect BTI to raise the dividend from $2.70 per share in 2023 to $2.81 in 2024 and $2.85 in 2025. This will depend on the effect of currency exchange rates which are the primary reason that the company’s dividend payout fluctuates year to year. The company has maintained or increased its dividend in pounds for 25 consecutive years. In 2022, BTI paid out $6.05 billion USD in dividends. BTI received £438 million in dividends from its stake in ITC Ltd. equivalent to about $540 million. This is growing quickly at 11.7% YoY, 1.6% in 2021, and 67% in 2020.

BTI may decide to reduce its stake in ITC and use the capital to pay down debt or, better yet, repurchase its own shares. It may also choose to keep the stake and share in the future growth of the company. Still, it is possible that the Indian government could intervene and either confiscate or force a sale by BTI to prevent foreign investment in the country. During the Q4 2023 earnings call on February 9, Group Finance & Transformation Director Tadeu Marroco said this of buybacks:

We strongly believe that share buybacks have an important role to play within our capital allocation framework and we will continue to keep it under review as we progress through the year.

Earlier this month, CEO Jack Bowles resigned and Tadeu has succeeded him as CEO. Tadeu has been with the company since 1992. While we support share buybacks, we do not agree with other analysts that the company should suspend or reduce dividends for share repurchases. Instead, we would rather let shareholders decide if the capital is worth redeploying back into the company.

Big Picture

All of this is to say that BTI has the appearance of a solid company with mediocre growth. Under normal circumstances, during the expansionary phase of the business cycle, these would not be the ideal set of conditions for our portfolio. However, we believe that the U.S. and globe has entered into the contraction phase of the business cycle. This is supported by the abundance of research that we publish regularly but can be summarized by the chart below with the 10Y-3M yield curve and recession probability index.

Given this macroeconomic backdrop, we are attracted to defensive equities, including consumer staples, with a track record of stable revenues, strong dividend, and solid margin of safety. We believe that BTI fits that bill well, thanks in part to the AI trend which has neglected companies like BTI. If we are correct about the business cycle, absent a new cycle of monetary easing we expect that high growth stocks will fail to meet market expectations. For these reasons, BTI is a high conviction, large position in our portfolios.

Summary

British American Tobacco is not without its risks. Demand for traditional tobacco products is waning, especially in the U.S. and other developed nations, and governments are actively working to make it difficult for tobacco companies to market products to consumers. This is double edged. While the regulation is a significant headwind, it also constrains competition.

The U.S. dollar and currency exchange rates are another headwind for BTI, although temporary. Often, the USD will strengthen in the face of recession until monetary easing begins. The popularity and momentum of AI related stocks is another temporary headwind for consumer staples like BTI. We conclude that BTI is a solid cash flowing company with good assets at a reasonable price. For investors that expect recession, like ourselves, this can be an ideal combination of qualities.