The British American Tobacco (BAT) stock attracts investors searching for high dividend yields. The price decline in 2018 combined with dividend increases have pushed the dividend yield of BAT over 8 percent. Tobacco stocks typically carry such high dividend yields but their stock prices have been under pressure in recent years.

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BAT achieves the highest turnover in the tobacco industry. Even if you do not smoke, brands like “Lucky Strike” are probably familiar to you. In this stock analysis you will find out whether the seemingly cheap valuation and high dividend yield of the BAT stock present an opportunity to enter the market.

BAT stock
Logo
Country	Great Britain
Industry	Tobacco
Isin	GB0002875804
Market cap.	77,2 billion $
Dividend yield	8.2%
Dividend stability	0.99 of max. 1.0
Earnings stability	0.98 of max. 1.0

The business model: How BAT generates sales

BAT is a London-based manufacturer of cigarettes, tobacco and other nicotine products. BAT is involved in the entire process from purchasing the tobacco leaves to distributing the final products to retailers. BAT works together with over one hundred thousand tobacco farmers and supports them with the necessary “know-how” to ensure the quality of this important raw material. The resulting products such as cigarettes are then distributed to wholesalers and retailers.

BAT’s product portfolio of classic cigarettes and Next-Generation-Products (NGP) includes more than 200 different brands. However, 40 percent of sales are generated with only five of these brands. The 200 brands include e-cigarettes, which have the potential to attract new customers that are non-smokers yet.. So far, BAT has been able to compensate for the decline in cigarette volumes by raising prices. In addition, NGPs now contribute 5 percent to the total revenues. BAT still generates the majority of its sales with cigarettes, but the NGPs are growing at impressive rates:

Growth of NGPs in 2019 (Source: BAT)

“Tobacco Heating Products” are another product category. They are like e-cigarettes but contain tobacco. However, unlike conventional cigarettes,  tobacco is only heated instead of burned. This is supposed to release fewer harmful substances. NGPs are the hope of the tobacco industry because sales volumes of conventional cigarettes have been on the decline.

The future of the conventional cigarette

The cigarette has blessed tobacco companies like BAT with stable and growing revenues for a long time. But the age of the cigarette is coming to an end. Sales volumes have been declining for decades, except for some regions in South-East Asia. On the one hand, many smokers are turning away from cigarettes for health reasons. On the other hand, some customers are switching to other products like e-cigarettes or the soft drug cannabis, which has been legalized in some countries.

Declining cigarette volume (Source: Statista)

This structural change forces the tobacco industry to adapt its product portfolio to new consumer preferences. At the same time, the conventional cigarette business must be continued in a profitable way to finance the development of new products and the dividend.

This change presents both risks and opportunities. One risk is the uncertainty surrounding the adoption rate of the NGPs. If customers dislike the NGPs, tobacco companies will likely lose revenues in the long run. Although most  smokers will continue to smoke in this case, fewer and fewer new customers will be acquired. It is also crucial that NGPs are adopted rather quickly. If the decline in conventional cigarette sales outpaces the growth of NGPs, it could lead to a decline in profits.

On the positive side, those new consumer preferences also create the opportunity to acquire new customers. Because products such as e-cigarettes or THP (Tobacco Heating Products) claim to be less harmful to one’s health, they attract customers who would not smoke conventional cigarettes. The switch to NGPs is already in full swing and can be seen in the figures in the 2019 annual report. From 2018 to 2019, sales in the “new categories” increased by almost 37 percent.  Overall, just under 5 percent of sales in the past fiscal year were generated by those products. Interestingly, however, sales of classic cigarettes also rose by more than 4 percent in 2019:

Strong revenue growth of NGPs (Source: BAT)

This positive trend is confirmed by the half-year figures published on July 31. In comparison to the previous half year, sales of both classic cigarettes and NGPs increased again. However, the sales increases of 0.3 and + 14.7 percent are now significantly lower, which is also due to unfavorable exchange rates for cigarettes. Without the exchange rate headwinds, the effect would have been 2.2 percent instead of 0.3.

Revenue growth in the first half of 2020

Considering the growing revenues there does not seem to be an issue with the business model right now. If this is the case, why has the stock price been falling? I suspect that many investors are skeptical whether the shift from cigarettes to NGPs will succeed. As you will see in a moment, the core business model of BAT is highly profitable.

How profitable is BAT?

BAT generates the highest sales in the tobacco industry and operates very profitably with a current operating margin of 41 percent. Margins have even improved in recent years. Simultaneously, revenues have also gone up. This is mainly due to the following reasons:

Development of revenues and the operating margin of BAT

The acquisition of Reynolds American

The chart above shows the strong revenue increase in 2017 and 2018. This is a result of the acquisition of the American tobacco company Reynolds American Inc, which was completed in mid-2017. In 2017, only the revenues of the second half of the year were consolidated in the financial results of BAT. Since 2018, the entire revenues of Reynolds are  consolidated, which explains the increase in sales in that year. For BAT, the acquisition was important to achieve higher margins through synergies. The annual cost savings of several hundred million (page 10) are reflected in the form of higher operating margins, which rose from 35 to 41 percent after the takeover. Analysts expect even higher operating margins up to almost 45 percent in the coming years.

Price increases to combat the volume declines

BAT is fighting the decline in cigarette volumes with price increases. Although fewer and fewer cigarettes are being sold, if the cigarettes sold become more expensive, the negative effect can be compensated. Below you can see a statement from BAT from the 2018 fiscal year on this topic:

Pricing Statement von British American Tobacco (Source: BAT)

In fact, BAT has been increasing the prices of its cigarettes for years. In 2019, the number of cigarettes sold fell by 4.7 percent. However, the turnover from cigarette sales increased by 4.2 percent. The price increases have therefore not only compensated the decline but have even led to an increase in revenue. Still, the strategy is not particularly promising. In my opinion, even addicted smokers will not accept these price hikes forever.

What will replace the cigarette?

“Next Generation Products” (NGP), in particular e-cigarettes and “tobacco heating products” (THP) have by far not yet reached the revenue numbers of cigarettes, but they are growing at impressively high rates. Last year, the turnover of NGPs increased by almost 37 percent, and their total turnover in 2019 already exceeded 1.2 billion British Pounds (GBP), i.e. just under 5 percent of total turnover and about 5.5 percent of cigarette sales. With such growth rates, NGPs are indeed the hope of the entire tobacco industry. If the NGPs take off, the declining volume of cigarettes can be compensated, and BAT will no longer have to depend on price hikes.

Revenues of E-Cigarettes and THP (Source: BAT)

Is BAT’s dividend safe?

Until 2018, BAT has paid its dividend semi-annually, one part every 6 months. Since 2018, the dividend is now paid quarterly. In the past 12 months, shareholders have received 2.70 USD, representing a dividend yield of 8.2 percent. This is well above the historic average. The Dividend Turbo illustrates that the dividend yield of BAT has generally ranged between 3 and 5 percent from 2009 to 2018. Since 2018, the yield has risen sharply, primarily due to the falling stock price. Since the dividend yield moves inversely to the price, it increases when the price falls.

Historical dividend yield of BAT

Fortunately, the payout ratio has hardly changed during this period and is just under 70 percent in terms of free cash flow. This may sound high at first but is normal for the tobacco industry. In addition, the dividend has been increased for 21 consecutive years. Despite rising profits and dividends, the stock price is at about the same level as it was in 2011, when shareholders still received a dividend of 1.19 British pounds (GBP). Today you will receive 2.07 GBP.

Price chart of BAT

Is the debt dangerous?

The Reynolds acquisition was strategically important for BAT but also cost a good chunk of money. As a result, the debt increased from 31 billion GBP to 80 billion GBP.

Development of the debt level of BAT

More debt also requires a higher interest payment. Prior to the takeover in 2016, the interest expense was 681 million GBP. Last year it was almost three times that amount at 1.8 billion GBP. That may sound dramatic, but it is not. The operating profit rose simultaneously with the interest expense. In 2016, the operating profit was 4.6 billion GBP and increased to 9 billion GBP in 2019. The share of operating profit spent on interest has therefore only increased moderately from 15 to 20 percent. Nevertheless, 20 per cent is not an insignificant amount. As a result, the management of BAT has announced efforts to reduce the debt and has already made progress. Total debt has been reduced from a peak of 80.6 billion GBP to the current level of 76.8 billion GBP.

How does the BAT stock stack up against the competition?

BAT belongs to a group called “Big Tobacco” which is made up of the world’s largest tobacco companies.

                                                       Big Tobacco on Dividendstocks.cash

The BAT stock can hold its own against the competition. With a dividend yield of over 8 percent it is at a similar level as Altria and Japan Tobacco.The extraordinarily high dividend of Imperial Brands is not representative because it will be cut by 33 percent. This cut is not yet reflected in the statistic but can be seen in the expected dividend growth:

Expected dividend cut of Imperial Brands in the Dividend Turbo

Is the BAT stock undervalued?

The BAT stock currently trades at a P/E ratio of 10 which seems cheap, since the stock has traded at significantly higher P/E ratios of up to 20 in the past. Other multiples such as P/C (price/cash flow ratio) and the historical dividend yield also indicate a significant undervaluation. To determine the multiples for the fair value calculation, I use a relatively short period starting in 2017, as this period reflects the new BAT after the Reynolds acquisition. The Dynamic Stock Valuation calculates the fair values based on this information and displays them graphically:

British American Tobacco in the Dynamic Stock Valuation

As a result of the massive price drop from over 55 GBP to temporarily below 25 GBP, the BAT stock seems to be clearly undervalued today. In fact, the stock was clearly overvalued until mid-2017. An overvaluation was followed by an equally strong undervaluation.

Since BAT is a dividend stock, the fair value dividend seems to be a suitable valuation method in addition to the fair values based on reported profit, adjusted profit and operating cash flow. The past irregularities in the fair value dividend were caused by the change in the payment schedules.

The fair value dividend is 38 GBP per share, which is 40 percent higher than the current price of 27 GBP. the following table compares the BAT stock to the other tobacco companies in terms of the fair value dividend.

Valuations of the Big Tobacco companies

The percentage value indicates the ratio of the price and the fair value dividend. Stocks with a value below 100 are undervalued according to this metric. The difference to the 100 percent mark indicates the extent of the undervaluation. The BAT stock is therefore 29 percent undervalued. It has a 40 percent upside to its fair value. In the table you can see that the other tobacco companies also appear undervalued. Considering that BAT is also very profitable and has a high dividend yield, the BAT stock is a good buy in my opinion. Especially since analysts are forecasting profit growth for BAT despite the pandemic, which you can see based on the rising fair values in the coming years.

8 percent dividend yield makes the BAT stock a good opportunity

The BAT stock, like the entire tobacco industry, has experienced sharp price drops. The fear of the future viability of the conventional cigarette has caused extended selling. In my opinion, Mr. Market has once again exaggerated, as price increases have so far been able to compensate for declining cigarette sales without any problems. In addition, BAT has NGPs with very high growth rates in its portfolio. Even concerns that the Corona pandemic will make smokers give up smoking have not been confirmed so far.

The fundamental strength of BAT, including high profitability and further growth potential, makes the BAT stock an attractive purchase in my opinion. Therefore, I seized the opportunity to buy stocks of BAT for my private portfolio. Until Mr. Market calms down and recognizes the fair value of the stock, shareholders -including myself – will receive a decent dividend in the meantime.