U.K.-based British American Tobacco (NYSE:BTI) stock is currently trading around its lowest valuation in at least the past 20 years (as far back as my data goes). This has been the result of shares undergoing a declining trend since 2017, which has been further aggravated by the recent aggressive interest rate hikes that have negatively impacted stocks. In the meantime, however, the tobacco giant has been delivering robust results and growing dividends, resulting in the stock currently featuring a very high yield of 8.1%.
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The combination of a low valuation and high yield combined with the company’s resilient business model and growth prospects have formed a very attractive investment case with a wide margin of safety. Accordingly, I am bullish on the stock.
Why Has BTI Stock Declined?
British American Tobacco stock’s prolonged decline can be attributed to two factors — investors’ dislike of the tobacco industry and the ongoing rise in interest rates.
Specifically, the tobacco industry has been grappling with a widespread trend of investor disinterest, with other giants like Altria (NYSE:MO) and Imperial Brands also bearing the brunt of this trend (LSE:IMB). This is due to a number of reasons, including the inherent risks attached to this heavily regulated industry, the industry’s anti-ESG nature, as well as fears of a declining smoking population over the long run.
Regarding interest rates, high-yielding dividend stocks like British American Tobacco are particularly sensitive to sudden hikes. Since investors expect that the majority of their future returns are likely to be sourced from the stock’s dividend, as the “risk-free” rate in the market advances higher, the returns demanded from investors from British American Tobacco also grow. In other words, the stock’s equity risk premium rises, resulting in shares declining and, therefore, the dividend yield advancing.
Resilient Results Despite Concerns
Despite the concerns sounding British American Tobacco, the company has been able to perform resiliently, with its results even rising last year.
Combustibles Segment
As the market rightly assumes, the company’s Combustibles segment experienced a 5.2% decrease in volumes, which was due to the long-term decline in the number of smokers. However, cigarettes are highly-addictive, inelastic products, which means that smokers are relatively insensitive to price increases. Therefore, the company tends to increase pricing in combustibles by a rate that usually exceeds that of the decline in shipment volumes. Hence, despite lower volumes in combustibles, British American Tobacco reported 4.5% revenue growth in this segment.
Non-Combustibles Segment
Of course, constantly raising prices is not a sustainable long-term strategy. British American Tobacco is well aware of this situation. Like its peers, it has been expanding its portfolio of non-combustible products, which have been rapidly capturing market shares in multiple markets.
In particular, the Vapour category, which includes the Vuze electronic cigarette, experienced a significant surge of 54.9% in Fiscal 2022. Additionally, the Glo tobacco-heating products and VELO oral tobacco also demonstrated impressive growth, with year-over-year increases of 24.3% and 45.3%, respectively.
Although these newly-added categories only contribute slightly more than 10% of the total revenues, their collective growth rate of 40.9% indicates a promising trend towards an increased percentage of revenue generated from smokeless nicotine products. Therefore, as the world gradually shifts towards this trend, British American Tobacco is well-positioned to take advantage of this change.
Profitability
With British American Tobacco reporting growing revenues in both its combustibles and non-combustibles categories, the company’s profitability also improved in Fiscal 2022. It’s worth noting that despite the latter segment’s impressive growth, the company has been investing heavily in advancing its technologies and acquiring customers. Thus non-combustibles (referred to as New Categories) is still an unprofitable segment.
Still, with scale, its margins have been improving, as the company posted an operating loss of £375 million, a considerable improvement from last year’s operating loss of £953 million. The combination of growing revenues and improving margins resulted in the company posting record adjusted earnings per share of £371.4, up 12.9% year-over-year.
Low Valuation, High Dividend
British American Tobacco didn’t just post record adjusted earnings per share last year. Buoyed by an optimistic sales outlook in both its segments, the company also anticipates a further expansion of this metric in the mid-single digits this year. As British American Tobacco keeps reaching new records in its bottom line against a declining stock price, its forward P/E ratio has now slipped to a historically low 7.2.
Simultaneously, the company continues to increase its dividend, as it has done for 34 consecutive years (in GBP). The most recent hike was by a decent 6% to a quarterly rate of £57.72, which at the stock’s current price levels (£2,848/share on the London exchange) implies a very high yield of 8.1%. The company remains committed to growing its dividend, with the payout ratio hovering at just 62% of adjusted earnings per share.
Overall, due to both its current valuation and yield, investors should now enjoy a considerable margin of safety from further downside. Not only is a further compression of the valuation unlikely, as it’s already quite depressed, but the hefty yield should attract investor interest and provide predictable, tangible returns in the meantime.
Is BTI Stock a Buy, According to Analysts?
Turning to Wall Street, British American Tobacco has a Moderate Buy consensus rating based on two Buy ratings assigned in the past three months. At $57.34, the average British American Tobacco price target implies 62% upside potential.
The Takeaway
British American Tobacco has defied the odds by consistently delivering outstanding results, despite operating within a challenging industry that the market has grown to disdain. Following the stock’s prolonged decline, its investment case now appears quite fruitful.
The convergence of a historically low valuation and an exceptionally high yield, coupled with the company’s tenacious business model and promising expansion prospects, has formed a highly-enticing investment opportunity with a considerable margin of safety. Thus, I recently initiated a long position in British American Tobacco.
