British American Tobacco (NYSE:BTI) (GB:BATS), or BAT for short, is an unloved and discarded company with a 10% dividend yield. Despite operating in a changing industry, BAT’s wide moat and pricing power have remained intact, as evidenced by its growing revenues and consistently high gross margins. Combine this with a bargain valuation (6.4x free cash flow multiple), and I’m bullish on BTI.
The $34.8 Billion Impairment
At the end of 2023, British American Tobacco took a $34.8 billion non-cash impairment charge (£27.6 billion). This reduced the value of the company’s balance sheet assets and caused a large non-cash loss on the income statement. This sort of thing can happen from time to time when a company overpays for an acquisition. In this case, British American Tobacco overpaid for Reynolds American back in 2016. It’s fair to say there have been some unforeseen headwinds in the meantime.
Here are the company’s own words on the write-down:
“Taking into account the current macro-economic pressures impacting the U.S. combustibles industry, the growth of illicit single-use vapour products and uncertainty around a potential menthol ban in the U.S., we have taken a non-cash impairment charge of £27.3 billion, mainly relating to our acquired U.S. combustibles brands.”
Source: British American Tobacco p.l.c.
We have a couple concerns to unpack here. First, I believe the illegal sale of vapor products will get better over time. The black market for cigarettes isn’t a large one, and regulators should find a way to limit the black market for vapor products as well. Then, there is the potential for a menthol cigarette ban in the U.S. This could adversely affect BAT’s earnings if consumers choose to switch to another company’s products.
Still, I’m not too worried. I suspect that in the event of a ban, many of BAT’s menthol cigarette consumers would simply switch to a flavorless product of the same brand.
In summary, this non-cash charge isn’t all bad. First, having a smaller balance sheet (with less goodwill) will increase the company’s return on equity and return on assets in the years to come, all things equal. Also, if we exclude this charge from last year’s earnings, the company made an operating profit of $15 billion (£11.85 billion).
Gushing Cash and Paying Dividends
Now that we’ve debunked some of the fears around the recent impairment charge, let’s look at the bullish case for British American Tobacco, primarily the company’s cash-flow generation.
Looking at the 2023 cash flow statement, if we deduct the business’ net CapEx (£487 million), dividends to non-controlling interests (£105 million), and net interest and lease payments (£1,763 million) from its cash from operating activities (£10,714 million), we get £8.36 billion of free cash flow ($10.53 billion).
This easily covers the company’s £5.055 billion of common dividends paid ($6.37 billion). Despite the recent headwinds, BAT expects to generate £40 billion of free cash flow over the next five years. So, the 10% dividend yield appears rock solid.
Resuming Buybacks?
Given that there’s ample cash left over after paying dividends and that the business is nearing the middle of its net debt target, British American Tobacco may soon resume share buybacks. This would be a major catalyst for the optically undervalued stock.
A Solid Moat
I believe that British American Tobacco has a solid moat. Because tobacco is such a heavily regulated industry and advertising is illegal in many markets, there are substantial barriers to entry. This only strengthens the power of BAT’s existing brands.
Also, big players like British American Tobacco, Altria (NYSE:MO), and Philip Morris International (NYSE:PM) benefit from economies of scale, allowing them to buy tobacco leaves from farmers at a discounted price.
This scale also shows up in the distribution chain where British American Tobacco delivers larger quantities of product to retailers and is thus more efficient (similar to Coca-Cola (NYSE:KO) and Pepsi (NASDAQ:PEP), which enjoy this same advantage). This is why you see market share so concentrated among the big players.
BAT’s moat shows up in its gross margin. Despite a challenging and changing market in recent years, British American Tobacco has maintained strong gross margins, which stayed stable at around 82% from 2018 through to 2023. The company even maintained this margin through the unemployment spike of 2020.
Big Tobacco Deserves Its Bad Rap
Another reason tobacco stocks are so cheap is because their products are addictive and harmful. For this reason, I have avoided owning tobacco stocks until this point. Over the years, tobacco companies have seen a lot of lawsuits and have adapted to a lot of new regulations. This has made the tobacco industry a lot more transparent. Most people now know cigarettes are unhealthy. But, like coffee, sugar, marijuana, and alcohol, tobacco will likely never go away.
Some people enjoy tobacco, while others want to quit but can’t. Thankfully, consumers now have a potentially healthier alternative — vapors. British American Tobacco is pushing for a “smokeless future” in which 50% of its revenue will come from non-combustibles by 2035. There is some concern this segment will not be as profitable, but it is growing rapidly for BAT and just achieved profitability two years ahead of schedule. I would compare this to Coca-Cola’s move to introduce Diet Coke in the 1980’s.
Sentiment is currently very negative on the tobacco industry, but society’s views on substances can change over the years. For example, the United States had a prohibition against alcohol in the 1920s. Today, alcohol is socially acceptable in North America despite its adverse health effects. When it comes to big tobacco, I hope that the future will be less negative than the past.
Is British American Tobacco Stock a Buy, According To Analysts?
After a big sell-off, six of 11 analysts covering British American Tobacco now give it a Buy rating, while five rate it a Hold, giving it a Moderate Buy consensus rating. The average BATS stock price target is 2,933p, implying upside potential of 25.85%. Analyst price targets range from a low of 2,400p per share to a high of 4,000p per share.
The Bottom Line on BTI
British American Tobacco has ample free cash flow to pay its 10% dividend and should have cash left over should it choose to resume share buybacks. Further, shares plummeted following the company’s non-cash impairment, but this should increase ROA and ROE in the years ahead.
Despite fears of a changing industry, BAT has maintained an 82% gross margin over the past five years, displaying a rock-solid moat akin to Coca-Cola’s. Finally, a fast-growing non-combustibles business that just became profitable bolsters my conviction on the stock.
