A Balanced Look At Heavily Discounted Tobacco Stocks – Part 2: British American Tobacco – British American Tobacco p.l.c. (NYSE:BTI)

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Quick Introduction & Background

In the first article in the series, “A Balanced Look At Heavily Discounted Tobacco Stocks – Part 1: Altria Group”, we set the stage by explaining our investment rather than “socially responsible” focus, macro level smoking data via the Center for Disease Control, and the impressive historical returns the tobacco industry has generated despite many headwinds. We’ll reiterate one element of Part I’s introductory section:

Let’s look through a different lens based on hard facts and data rather than perception: over the past 30 years, Altria (MO) and British American Tobacco (BTI) have delivered approximately 17% and 13% compound annual growth, respectively. This time period was “cherry picked” to include the full breadth of the gigantic settlement that put an albatross around the neck of U.S. tobacco companies to the tune of hundreds of billions of dollars.

Not only did British American Tobacco beat the S&P 500, it outperformed by over 500 basis points (5%) annualized. Altria also delivered, and in aggregate, the Tobacco Products sub-sector has been #1 within the S&P 500 within the last 30 years. Falling smoker rates, tougher regulation, curtailing of marketing campaigns, and all the other justifiably commonly cited issues are fully baked into this period. In the last decade, however, the results paint a different picture.

Source: Yahoo! Finance

Altria Group performed well and is up just over 200% on a total return basis over the period. Philip Morris (PM) achieved about half that performance with BTI only up modestly on a capital gains basis (~15%), but still posting a reasonable annualized return of approximately 9%. These are good numbers, but do not “dominate” the S&P 500 like tobacco has in the past.

Source: Yahoo! Finance

On a total return basis, which is what counts, Altria performed similarly to the broader equity markets, but both PM and BTI trailed well behind it. The reason this background matters is because it begs a key question: is the return dispersion relative to long-term norms due to A) changes in underlying business profitability or B) temporary fluctuations in valuation?

If the prior, the weaker performance compared to historical averages may be justified. If the latter, these stocks are likely strong buys with significant upside potential in the medium to long-term. Short-term, as we discussed in the Altria article, we have to assume volatility and downside risk may remain for headline risk and regulatory reasons. There are not many stocks this same statement does not apply to, but it is worth reiterating.

Source: British American Tobacco.

British American Tobacco posted its most recent financial data on September 12, 2019. We’ve spent the last couple weeks analyzing these results as well as putting them into the broader context of the firm’s long-term performance, the quarterly results of its peer group, and various regulatory developments. There is a lot going on with British American Tobacco. The firm has multiple brands across multiple product lines sold in multiple continents. On top of that, the Reynolds American Inc. (“RAI”) acquisition significantly expanded the company’s foothold in the U.S. and complicated analyzing its financial results. Not only that, but also the current CEO, who has been at the helm since 2011 and part of BTI for 37 years, is stepping down in a few months’ time. Let’s go through the key aspects of our findings starting with an often overlooked area.

Efficiency

A major driver of the tobacco industry’s ability to offset the structural decline in the number of smokers is improving the operating efficiency of their business models. We know BTI’s peers have done this successfully so how does it stack up? In recent years, BTI has reduced the number of reporting business units from 28 to 18 or a 36% reduction. Through decreasing the number of reporting units and layers of management, regional support team costs are on track to decline 50% by January of 2020. BTI recognized the ability to improve efficiencies in what it considers “tail markets” or non-core. An effective way to gauge if a cost-reduction plan is in fact comprehensive is the effect on senior management. In BTI’s case, over 20% of senior management is impacted by the ongoing cost optimization suggesting this is indeed a serious plan.

Financial Operating Metrics

Aggregate volumes declined 3.5% in the first half of 2019, which is in line with what we’ve seen from the other large tobacco companies. Its group market share was also flat.

Source: British American Tobacco.

We mentioned those first two stats because they were the only negative aspects of its operations we consider meaningful. As the diagram above demonstrates, BTI’s adjusted revenue, profit, and diluted EPS were all up 4.1% or more compared to the first half of 2018. Importantly, we are backing out “unrepresentative” numbers from the Reynolds acquisition that would muddy the waters.

7.1% EPS growth is no small feat; it indicates the company could grow the long-term distribution rate at that level going forward, which is among the highest of any large-cap company. 2018’s full-year performance was +12% EPS, +3.5% net revenue, +40 basis points improved margins, and approximately $4.0 billion in free cash flow. We will be using 1.20 as the exchange rate between the USD and GBP when applicable.

Source: British American Tobacco

While BTI expects marginal gains within its traditional markets, the new product segments are the ones that are experiencing the real growth as shown in orange. BTI calls these its “Strategic Portfolio” which overlaps with its “potentially reduced-risk products” (“PRRP”) division.

Source: SEC.gov 6-K

These are good terms to know as you work through the firm’s financial data and reports. While these areas long-term success is uncertain, current data suggests the new divisions are doing very well in aggregate.

One area we see a major advantage for BTI, even against other top tobacco companies, are margins and profitability.

Source: SEC.gov 6-K

2018’s full year profitability was up 45% versus 2017. That’s impressive in its own right but even more so given 2017’s profits were up 38% versus 2016.

Source: SEC.gov 6-K

The growth in Adjusted Earnings Per Share (“EPS”) has slowed versus prior years but remains positive.

Source: SEC.gov 6-K

These are not accounting gimmicks or the function of unsustainable cost reductions; revenue rose 13%, 39%, and 25% in 2016, 2017, and 2018, respectively. Those percentages are based on GBP earnings, so the cumulative increase (e.g. 1.13*1.39*1.25=1.96) of 96% is reduced by the depreciation of the British pound ((1.2/1.4)-1) of approximately 14% over the period for net USD gains in revenue of 82.3%. You can reduce any other cumulative three-year figure by the same 14% to convert to USD as you go through SEC filings and company reports.

Source: SEC.gov 6-K

The growth in profitability is in line with the other metrics and very healthy. These figures demonstrate consistent operating margins of 32-40% with 2018’s landing just above the midpoint at 37.9%. These are extremely strong margins on an absolute and peer comparison basis. Adjusted margins backing out what BTI considers non-recurring factors are even stronger at 35-43% (42.6% in 2019). While the tobacco sub-sector consistently earns above-average margins, BTI averages approximately 10% better than any peer we’ve reviewed.

On that note, let’s discuss the new categories critical to its medium- and long-term success.

Offsetting Decline In Traditional Smokers

BTI and its peers are keenly aware of the structural decline in traditional smokers throughout most of the West including its home country of the U.K. and the U.S. Although they’ve offset this trend admirably, as long-term investors, we need more than cost reductions to keep these companies growing revenues and distributions in the future. The major tobacco companies are investing heavily in the vapor (or “vapour” across the pond) and other developing markets for just that reason. We discussed this in the Altria article in substantial detail and explained that the firm’s very large $12+ billion investment in JUUL, a leading e-cigarette manufacturer, as a potential positive or negative catalyst. These markets are fascinating because it is bringing millions of totally new customers to what has otherwise been a dying market (I couldn’t help myself).

Like its peers, BTI has been active in the mergers and acquisitions space which makes getting a strong grasp on its various brands difficult. Unlike several of its peers, BTI undertakes a more global approach to both the traditional and emerging tobacco-related products.

Source: SEC.gov

As shown above, adjusted revenues and profits were up across the board in 2018. Its acquisition of Reynolds coupled with various international brands has given BTI double-digit market share in the vaping segment in several of the world’s wealthiest countries including the U.K., (41%) France (16%), and Japan (17%).

Source: SEC.gov 6-K

BTI is not just talking about product diversification and expansion overseas, it is executing.

Source: SEC.gov 6-K

Source: SEC.gov 6-K

The firm’s new brands in the “pouches” and vape categories are experiencing very rapid growth of approximately 100% annualized.

For those that noticed the giant spike in 2017 non-adjusted EPS and subsequently large decline (-86%) in 2018, it is due to accounting gains including deferred tax credits related to the acquisition of RAI coupled with the changes in U.S. tax law occurring at the time. After accounting for dilutive employee share awards and the RAI items, “real” EPS rose 5.2% from 2017 with that year up 16.0% versus 2016.

It’s mandatory to understand both the strengths and weaknesses of a company which includes its management. Think along the lines of: What are tobacco companies truly skilled at? Are they taking advantage of this competitive edge? How much growth is realistic by applying it?

One skill they have is undoubtedly marketing. Another is successfully wading through the dark waters of regulatory change while less experienced players sink around them. The strongest tobacco companies have keenly entered several new industries that are almost completely marketing driven with increasingly complex regulatory oversight. Coincidence? I do not think so.

The fact companies like Altria and British American Tobacco are experiencing double and in some cases triple-digit annual gains in vaping and other “new” tobacco/nicotine related markets shouldn’t be a surprise to anyone who understands these firms well. That doesn’t mean it’s going to “save” them completely but credit where credit is due.

As investors, we need to ensure the companies allocate sufficient resources without getting carried away or taking disproportionate risk. In Altria’s case, it doubled long-term debt through a very pricey acquisition (many times sales much less earnings) of one third of JUUL. It’s clear British American Tobacco is strategically and successfully expanding into global markets with new product lines, but at what cost? The recent purchase of Reynolds, bringing BTI back to American shores for the first time in 12 years, was far from free. Let’s review the balance sheet and make sure its expansion has not come with too heavy of a price tag.

Balance Sheet

We remember from our Altria article that the company recently expanded its liabilities considerably due to the acquisition of JUUL, effectively doubling its long-term debt and associated ratios. We highlighted this as a primary but surmountable risk factor and contributor to the stock’s recent decline. Let’s start by analyzing the cost the market demands from British American Tobacco’s debt. The debt markets are almost exclusively institutional investors looking through a very different lens than equity investors. It is important to remain humble and always take the debt markets’ opinions seriously.

Source: SEC.gov

The filings for foreign companies are unique compared to their U.S. counterparts. The image above was pulled from BTI’s 424B5 filing submitted to regulators on September 5, 2019. An aggregate of $3.5 billion ($3.4815 billion after underwriting costs) in notes are being offered with interest rates ranging from 2.789% due 2024 to 4.758% due 2049. Not many companies earn sufficient respect from the credit markets to issue debt out to 2049 and even fewer at sub-5% interest rates. Doubly so given BTI’s decent but not spectacular credit rating. These low interest rates are attached to bonds very different from the first lien senior secured loans we are accustomed to in WER’s articles on Business Development Companies (“BDC”). In fact, the notes are unsecured and structurally subordinated to other debt on the balance sheet. These are unusual terms in the current environment but are nonetheless favorable for BTI and its investors.

Many investors are frustrated by variance in financial reporting between U.S. and foreign issuers and understandably so. Most of the data is available, however, if you know where to look.

Source: SEC.gov

This chart is helpful as it includes an “As adjusted” column demonstrating the financial condition after this bond issuance takes place. Cash levels are strong at 5.8 billion USD or £4.8 billion using June 30’s exchange rate of GBP 1.00 = 1.20 USD. We also see that approximately 15% of the BTI’s guaranteed bonds are eliminated through the new lower-cost $3.5 billion unsecured issuance. Given only a portion of the new debt offering went toward reducing higher-cost outstanding debt and the rest added to cash, we know that net debt must rise. Total borrowings after adjusting for the most recent debt offering are $62.2 billion compared to $78.6 billion. For context, BTI’s market capitalization is only 5.1x times Net Equity and 0.6x Enterprise Value.

Governance & Sustainability Measures

In a subscribers-only piece, our lead portfolio manager discussed a series of takeaways from his recent international business travels. “Sustainability” and various “socially responsible” measures are becoming increasingly important globally and the repercussions are finally bleeding over to the U.S. companies and institutions. Personal thoughts on this are irrelevant to the point we are making; global institutions and investment managers are increasingly being required to invest in firms following these guidelines and reporting parameters so it affects everyone.

Europe has already adopted these measures and reports on the breakdown of its board and senior management by gender, for example. BTI shines here being domiciled in Europe. While other companies will absorb higher personnel and reporting costs as the trend toward U.S. firms adopting these measures likely continue, BTI has little to no updates to make in this area. BTI even tracks its water and CO2 emissions which happen to be down year-over-year. If a certain political party (cough, cough the Democrats) were to gain the presidency, it is an immediate advantage for companies already fully engaged in European sustainability and diversity reporting standards.

BTI also places greater emphasis on the construction of its board of directors than most firms we review. Larger, international corporations, particularly those with assets in Europe, tend to excel in this area but higher quality U.S. companies aren’t far behind. The continued shift toward and investment in the PRRP is a recent example of the board’s directives. The company has noted communication with the U.K.’s “Serious Fraud Office,” but it’s hard to discern what is the range of implications from a brand or financial perspective. Regardless, the company has been transparent about the communication so some if not most of the downside risk is likely priced in.

One element of the institutional due diligence I perform rarely discussed during analyses of public companies is board construction and experience.

Source: SEC.gov 6-K

While there are more British members than any other nationality (4), America, Brazil, France, Germany, Canada, Italy, and Ireland are represented. Outside of adding at least one member from Asia, this board is about as good as we’d build ourselves and encompasses substantial personal and professional experience in nearly all of BTI’s key markets. Savio Kwan, as you might guess from the name, does have significant experience in Asia and specifically Greater China.

Savio previously worked as COO at Alibaba (NYSE:BABA), as one example. That partially mitigates our concerns particularly when combined with Korean representation within BTI’s Management Board. Another area we critically review is the audit committee. The risks identified by committee, as well as its policies and engagement with the external auditor KPMG, are in line with what we expect from a top-tier company. Overall transparency (the exact times each board member attended a scheduled meeting and precise amounts paid to KPMG for each auditing service year by year are documented, for example) is excellent and better than almost all U.S. based firms. In aggregate, we rank BTI very high in corporate governance and sustainability preparedness.

Valuation

One item we have not yet mentioned is British American Tobacco’s nearly 7.5% dividend as we purposefully saved it for this section. A major if not the primary reason tobacco companies have bested the S&P 500 over many decades is because their distribution yields are out of sync with the risk profiles. That can be measured by their credit ratings, leverage ratios, risk management, consistency in revenue, margins, or return on equity, or business durability. What happens next is a simple equation starting with the compounding effect of the 6-9% yield year after year. The second components are extremely consistent and above-average margins and return on equity. This is the engine that sustains the high yields. Thirdly, revenues, from which those profits are derived, and contrary to popular belief, have been maintained or increased over time.

This is possible because historically there has been an emotional/irrational misallocation of capital away from tobacco companies. The illogical (we are looking at this strictly from the investment point of view) avoidance moves the distribution yield artificially higher per unit of risk. Each share continuously provides investors more dollars in earnings and return on equity on a percentage basis than the broader market. In effect, we have the “ultimate” value play. Alcohol, and on a longer timeline the oil and gas super majors such as Exxon Mobile (XOM), have performed similarly for similar reasons.

Source: Macrotends.com & WER

Now is an even more compelling opportunity as the tobacco stocks are trading near 10-year lows on an earnings multiple basis. BTI’s 20-year dividend growth is approximately 11% annualized, which is very strong. More recent figures are weaker, but respectable; the five-year growth rate is 7%. Incorporating BTI’s BBB+ credit rating and 4-4.5x net debt to EBTIDA levels, interest expense ratios (~6.0x interest coverage), and approximately 65% and 55% distribution payout ratio on a trailing 12-month basis using earnings and free cash flow, respectively, we have significant margin for error by investing at today’s price levels. Adjusting for the accounting associated with the RAI transaction, the stock trades in the bottom decile of its historical earnings multiple range. This shouldn’t surprise us given where the distribution yield is relative to historical norms despite the conservative payout ratio. We reserve specific entry points for subscribers, but current price levels are fair.

Including the nearly 7.5% current cash yield, a return to the midpoint of historical averages results in well over a 50% total return. The safety of the dividend and extremely powerful consistency of revenues, margins, and earnings help offset near-term regulatory and headline risk.

As always, thank you for reading and commenting. – WER

Thank you for reading.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MO, BTI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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