British American Tobacco (BTI)
An "Unpopular Large Cap"
British American Tobacco (BTI)
Price: $31.08
Fully-Diluted Shares Outstanding: 2,215.25M
Market Cap: $68.6B
Enterprise Value: $112.9B
“I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty.” - Warren Buffett (Buffett bought RJR in the early 1980s and made a nice profit.)
British American Tobacco (BTI), founded in 1902, is a leading tobacco company with a diversified portfolio of cigarette and nicotine brands (Vuse, glo, Velo, Grizzly, Kodiak, Dunhill, Kent, Lucky Strike, Pall Mall, Rothmans, Camel, Natural American Spirit, Newport, etc.) and global footprint across developed and emerging markets.
“If we assume that it is the habit of the market to overvalue stocks which have been showing excellent growth, it is logical to expect that it will undervalue — relatively, at least — companies that are out of favor because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should prove both conservative and promising.” - Benjamin Graham
Graham would call these stocks “Unpopular Large Caps”, and British American Tobacco deserves the label.
Consider the symptoms: the tobacco behemoth has seen low single-digit free cash flow growth over the past five years, compared to its historic 6-7%. After levering up to purchase RJ Reynolds in 2017, the company has written the asset down to zero, a $31.5 billion hit. Cigarette volumes have continued their dizzying decline. A menthol ban could take another chunk of revenues, along with an illicit vape market. Pessimism is rampant, and investors believe tobacco stocks will never warrant premium multiples due to strict government regulations and more money flowing to ESG-friendly assets.
Unpopular, deeply hated, and misunderstood. The market has diagnosed BTI as terminally ill, but it’s just a common cold.
– Cash generation: BTI produces $13.07 billion of free cash flow on $586 million of capital expenditures. The company has paid a dividend for 25 consecutive years and is well-covered (~50% payout). Their pricing power on cigarettes has allowed them to generate cash despite declining volume and gradually invest in non-combustible products. ~80% of their revenues are from combustibles (cigarettes), the remaining from RRP’s (reduced-risk products).
– Consumer Hierarchy: Cigarette volumes peaked in 1977, and cessation rates have been stable for decades. In 2001, US sales of individual cigarettes were at 398.3 billion versus 173.5 today, but pricing power has allowed meager growth. In 2023, cigarette volume decreased by 8%, double the long-term average, and panic ensued. However, a brief look at history would show the last time this happened was in 2009. Perhaps we are already in a recession, and a company with a royalty on low-priced, highly addictive dopamine hits should do well in both inflationary and deflationary environments. Moreover, technological obsolescence risk is low; nicotine cravings will be around ten years from now.
– Regulation: The government has been a great partner for big tobacco. Strict oversight, constant compliance, and limited advertising mean near zero threat of entrants, resulting in enormous economic high ground. Big tobacco/nicotine will only get bigger. The illicit vape market is currently filled with the regulated vape users of the future.
– Geographic diversification: Half of BTI’s revenues are from the US, and smoking is much more prevalent in the rest of the world. BTI would benefit from a weakening dollar more than Altria per se, but this is not germane to the thesis.
– Capital allocation: Management has done an adequate job: paying down debt, issuing dividends, and recently selling their ITC stake (at 26x earnings) to fund their buybacks. CEO Tadeu Marroco remarked in the H1 2024 press release: “In March, we completed the monetization of a 3.5% portion of our ITC stake, enabling the initiation of a sustainable share buy-back, starting with £700m in 2024 and £900m in 2025. We are making good progress on deleverage and expect to be within our narrowed leverage target range of 2.0-2.5x adjusted net debt / adjusted EBITDA by year-end 2024”. Selling expensive shares to buy back at an 18% free cash flow is highly value-accretive and should be repeated until the multiple re-rates.
– Debt: The balance sheet has been substantially de-levered. Net debt/ EBITDA has decreased from 5.8x in 2017 to 2.6x today. Per their most recent annual report: “Our liquidity profile remains strong, with average debt maturity close to 10.5 years and maximum debt maturities in any one calendar year of around £4 billion”.
– Low valuation: BTI trades at a P/FCF of 5.3x (LTM) and a TEV/FCF of 8.6x (LTM), offering a 9.3% dividend yield. Sluggish growth capitulated the stock, and the market has overreacted to a previous incorrect forecast of perpetual earnings expansion. A business of this quality is worth at least a 10x earnings multiple. However, even if there is zero growth and the multiple doesn’t budge, the 10.5% shareholder yield (dividends + buybacks) provides a decent return.
“The key requirement here is that the enterprising investor concentrate on the larger companies that are going through a period of unpopularity. While small companies may also be undervalued for similar reasons, and in many cases may later increase their earnings and share price, they entail the risk of a definitive loss of profitability and also of protracted neglect by the market despite better earnings. The large companies thus have a double advantage over the others. First, they have the resources in capital and brain power to carry them through adversity and back to a satisfactory earnings base. Second, the market is likely to respond with reasonable speed to any improvement shown.” - Benjamin Graham
Several notable Buffett “Unpopular large cap” investments include American Express during the salad oil scandal (1969), PetroChina (2002), Bank of America (2011), Apple (2016), and most recently, Japanese trading companies (2020).
Meta Platforms was an unpopular large cap (the stock plummeted 70%) bought by prominent investors in 2022. It’s gone up about fivefold since the bottom tick.
History often rhymes, and in this case, British American Tobacco is a slant to the investments above. The stock is safe and cheap.