British American Tobacco offers the potential for excellent returns over the next few years. This is due to the dependability of their primary business and the growing sales of their new potentially reduced risk products. Additionally, British American Tobacco currently supports a high dividend yield and a near historically low PE ratio. Taken together, I would rate British American Tobacco 4/5 stars for quality and 4/5 stars for valuation.

• Highly regulated primary combustible business with dependable long-term cash flows
• Robust new categories that are establishing across markets, have strong sales growth and have the potential to be reduced risk compared to conventional cigarettes
• Boasts a great valuation due to a low price to earnings ratio and potential for moderate earnings growth

• Has higher debt and leverage following Reynolds American Inc. acquisition
• Core business is in long-term decline

Business History and Overview:

British American Tobacco (NYSE: BTI) is the largest tobacco company in the world that markets tobacco and other nicotine products. British American Tobacco acquired the remaining stake of Reynolds American Inc. starting in 2017. They currently sell products in 175 markets, have over 11 million points of sale and have 150 million consumers daily.

British American Tobacco faces criticism due to the dangerous health hazards associated with their combustible products. This has led British American Tobacco to begin transitioning away from cigarettes to next generation products.

The company currently sells the following products:

1) Smokeable tobacco products: Involves manufacturing and distributing cigarettes including Dunhill, Pall Mall, Lucky Strike, Kent, and Rothmans. US specific brands include Newport, Camel, and Natural American Spirit

2) New categories: Involves new products that have the potential to have less risk than conventional cigarettes. Includes glo (tobacco heating product), Vuse (electronic cigarettes), Velo (modern oral) and Grizzly (traditional oral tobacco product).

Business Quality:

One of the strengths of British American Tobacco is their consistent sales of their core combustible business and their growing new product sales:

Traditional combustible products (i.e. cigarettes) makes up the majority of British American Tobacco’s sales (data for 2022 is annualized). These sales have been relatively stable, with minor revenue increases in the United States offsetting declining revenues across sales in the rest of the world. While smokeable products have seen stable sales, the volume of sold smokeable products have steadily decreased:

Volumes of combustible products have been decreasing despite the boast in volumes from the acquisition of Reynolds American. A large part of this decrease is due to initiatives to increase awareness of the dangers of smoking (currently the leading cause of preventable death) and reduced cigarette usage. However, another reason for this decrease is the expansion of their new categories to transition adults away from traditional cigarettes:

The potential reduced risk products had steady growth since 2018, with all new categories growing over 30% in 2021. The products that makes up the majority of the new category are shown below:

• Tobacco heating products (glo): Sold in 25 markets
• E-cigarettes (VUSE): Sold in 30 markets
• Modern Oral (VELO): Sold in 24 markets

Tobacco heating products makes up the bulk of the new categories with 50% growth in sales per year on average. According to British American Tobacco, a large part of the focus on selling tobacco heating products stems from findings from the UK Department of Health in 2017 claiming people using THPs were exposed to around 50–90% less of the “harmful and potentially harmful” compounds compared with conventional cigarettes.

E-Cigarettes have also seen comparable growth to tobacco heating products over the last five years. British American Tobacco claims that Public Health England issued a series of expert reviews concluding: “based on current knowledge, vaping is at least 95% less harmful than smoking”. The majority of the vaping revenue comes from the United States, where Vuse holds nearly 38% of the vaping market. Additionally, British American Tobacco is only one of three companies with FDA approval for vaping products.

British American Tobacco also have strategic investments in KBio Holdings Limited to focus on developing novel-plant based therapeutics to treat diseases and a collaboration with Organigram for cannabis production. Finally, BTI has implemented cost saving procedures with the intent to decrease costs by £1.5 billion and consolidate their debt.

In terms of quality, I would rate the company as high quality (4 out of 5 stars). I believe that British American Tobacco’s large and diversified business provides the company with dependable cash flows. British American Tobacco also boasts high profitability (especially gross margins) due to the highly regulated tobacco environment globally. The company also has a long history of paying a dividend (at least 20 years) and currently has about a 6.5% dividend yield.

One main concern I have with British American Tobacco is the steady decline of their core business. Excluding the United States, most revenues from combustible products have been declining over the last few years. This has been mostly offset with increasing revenue from sales of combustibles within the United States. However, the success of their new categories will be critical to sustain future revenue growth going forward. Fortunately, both their tobacco heating products and E-cigarettes have seen strong growth in sales over the last five years.

Another concern with British American Tobacco is their debt following their acquisition of Reynolds American Inc. (£35.66 billion borrowings). The company has been focusing on paying down debt and their average debt maturity is in a decade. British American Tobacco currently has a good credit rating of “BBB+” from Standard and Poor’s and their operating income covers nearly 7X their interest (which is just shy of my 7.5X target). I believe that British American Tobacco will continue to focus on managing their debt to improve their credit moving forward.              

Valuation:

The company’s stock price had a major correction in 2018/2019, with the forward PE ratio currently under 10X.

Despite this negative sentiment, British American Tobacco has developed a robust portfolio of potentially reduced risk products that could drive meaningful and sustainable sales going forward. My reasoning for this is below:

1) The sales of the new category products have been phenomenal. The product volume is increasing by nearly 50% per year on average and revenue growing about twice as fast.

2) The company predicts 4% revenue growth this year and high single digit growth of EPS over the medium term.

3) British American Tobacco has collected evidence to support their new products can reduce consumer exposure to known toxins/carcinogens. This has the potential to create more sustainable and less heavily excised taxed products.

Let’s assume that British American Tobacco is successful in meeting its goal of generating £5 billion in revenue from their new categories by 2025 (which I believe they are currently on track to surpass). Let’s also assume that the revenue from combustibles continues to decrease by about 1% per year. Additionally, let’s also assume that British American Tobacco will make about £1 billion in share repurchases now that their debt is closer to their desired long-term goal (2022 should have about £2 billion in share repurchases for comparison).

Based on these assumptions, I think a conservative estimate is that earnings will grow by about 2.75%. This could have the potential to lead to excellent returns:

If these assumptions are correct, then at the current share price British American Tobacco could have the potential to deliver a significant nearly 14% compounded return over the next five years. Interestingly, Yahoo finance currently predicts that British American Tobacco is expected to have even higher long term growth, with their estimate being about 11.8% growth per year. Based on this analysis, my opinion is that British American Tobacco should receive a 4 out 5 stars for valuation.

Risks:

Investing in British American Tobacco does come with a number of potential risks. As mentioned earlier, cigarettes are currently the leading cause of preventable death. This has led to significant regulations on tobacco sales, with some countries entirely banning cigarettes sales for future generations.

There have been major lawsuits against tobacco companies, including the master settlement resulting in over $206 billion of costs to tobacco companies. Tobacco companies are also taxed by the government via excise tax, which could increase across British American Tobacco’s entire portfolio.

Competition from illicit trade also threatens to hurt British American Tobacco’s business, with 2011 data suggesting that 660 billion illicit cigarettes are smoked each year. Finally, there is controversy over the long-term safety of these new categories, which can impact the sustainability of these products.

Final Thoughts:

The overall negative sentiment towards tobacco companies, especially British American Tobacco, has created what I believe is a real opportunity for strong returns going forward. British American Tobacco has developed a robust portfolio of new products that are beginning to establish across multiple markets. These products are rapidly growing in sales and could ultimately have reduced risk compared to cigarettes. Furthermore, even assuming decreased sales of the core combustible products and slow growth of the new products, British American Tobacco could still have the potential for strong returns.

I also believe that the quality of British American Tobacco’s business is excellent, due to their consistent cash flows, new categories growth and the regulatory requirements to enter the tobacco space. However, the declining core business and higher debt levels lowers my quality rating to 4 out of 5 stars.

From my perspective, I believe that British American Tobacco has a great valuation with the potential for strong returns. For my portfolio, I will consider British American Tobacco a strong buy under $39.50 and a moderate buy under $44.20.

Disclaimer:

I currently own stocks mentioned in this article including British American Tobacco and Altria stock at the time of writing this post. I am not a financial advisor and I am not providing financial advice. I am sharing my thoughts and processes of selecting stocks for my personal portfolio for fun and entertainment purposes only.

All information provided here is on a “best of my knowledge” basis and may be incorrect. All estimates and models are guesses and may not be accurate. Stocks mentioned here may have additional risks not covered in the post.

Investing in the stock market comes with serious risk of losing money, please consult a professional financial advisor and do due diligence before investing.