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Is British American Tobacco a Good Value Investment?

Adam Brownlee, The Motley Fool


The cigarette industry is going through a major change as smokers switch to lower risk products. For British American Tobacco (NYSE: BTI) this has led to huge drops in traditional cigarette sales. At the same time, the FDA is talking about banning menthol sales in the United States. Due to these concerns, BTI stock has languished, trading down nearly 29% over the past year. Is this an opportunity for investors?

Sea change

Over the last few years, global cigarette sales have declined by about 3% to 4% annually.One of the main reasons for this drop is a shift to lower risk products such as vape and heat-not-burn devices. Consumers see these products as less risky because they do not release harmful chemicals though combustion.

In response to this sea change, cigarette makers such as British American Tobacco are putting muscle behind these alternative products. Altria (NYSE: MO) recently took a 35% stake in JUUL labs, the maker of e-cigarettes, and BTI recently invested more than $1 billion in a division devoted to alternative products. The problem? Currently, reduced risk products account for less than 5% of cigarette sales in the United States -- it might be some time before they replace traditional smokes' volume.

Image of Vype electronic cigarettes

Image Source: British American Tobacco

FDA

A shifting product landscape is not the only problem faced by BTI. On another front, the FDA plans to pursue a ban on menthol cigarette sales in the U.S. This would be a huge blow to BTI, as menthols represented about 55% of the company's U.S. cigarette sales by volume last year. To put this in perspective, BTI had total sales of GBP 24.5 billion last year. In the United States, the company had total 2018 sales of GBP 9.5 billion. As a result, about 21% of BTI's U.S. sales could be at risk if a ban on menthols is implemented. 

So what does this mean for investors? The decline in traditional smokers and a heavy-handed FDA has been a double-whammy for BTI. The stock is down 32% from its high last year and now trades at an earnings multiple of 11. Compared to its historic average multiple of about 16, this appears cheap.  If the fundamentals check out, this could be a buy.

Fundamentals 

 Sniffing out a bargain is only half the battle. If the company also has great fundamentals, then it might deliver great returns. Let's take a closer look at BTI. Despite the company's volume declines last year, BTI's revenue grew by 21%. Also, gross margins grew by just over 600 basis points. This can be explained by a powerful feature of tobacco companies: pricing power. Due to the addictive nature of cigarettes, tobacco companies can raise prices without much blow-back.  In turn, this can alleviate the headwinds from product shifts and heavy-handed regulation.

Diving deeper, we see that BTI had revenue growth of 23%  and earnings-per-share growth of 4.55% over the last three-year period. Importantly, revenue growth has picked up speed while earnings-per-share growth has slowed. This can partly be explained by an increase  in the number of shares outstanding. All else equal, investors benefit when a company buys back its shares, leaving a larger slice of earnings for those that remain. This is not the case for BTI, as the company has grown its number of shares outstanding from 1.99 billion in 2009 to 2.29 billion in 2018.  However, the company has an outstanding 10-year average return on equity (ROE) of 53.5%,   compared to an historic average of about 14% for American companies. The company also has reduced its total debt by 22% over the last ten years although it still has a high debt-to-equity ratio of 66%. Also, for income investors, the company has a juicy yield of around 7%. However, the payout ratio, the amount the company pays out in earnings, is close to 77%. As cigarette volumes wane, it may be difficult for BTI to continue to pay out at this level.  Overall, the BTI fundamentals receive a B grade.

Final analysis

In evaluating BTI, investors should ask a couple of key questions: can the company successfully compete in non-combustibles, and will the FDA ban menthol cigarettes in the United States? To the first question, we see that BTI is taking alternative products seriously with its billion dollar investment. To the second question, yes it is possible that menthols will be banned in the U.S. -- Canada and the European Union have already done so -- but it could take years to accomplish this as regulatory hurdles are immense and tobacco companies will push-back. In the meantime, investors might want to take a look at these shares.

Adam Brownlee has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.