Alexander Belikov
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Alexander Belikov in J.T. Marlin,

British American Tobacco (BTI) – Turning the highest point into the dip

Target price: 124.00 USD
Current price: 114.00 USD 
Our opinion: moderate upside opportunities 
Street's opinion: moderate upside opportunities

With this note, we continue adding consumer goods companies to our analysis scope, now from the tobacco industry. The same macro problems are affecting the industry from the dollar strength to the emerging markets slowdown, although there are some differences – the most obvious one, the baby boom in China would not be affecting these companies soon. We see more exposure to the dangerous markets to be in, like Russia, Brazil etc. coupled with production costs nominated in US dollars, thus the effect of macroeconomic environment is even fiercer in this case. Though looking at the chart, it is hard to tell the industry is very challenged, at least from the market perspective.

Nielsen offtake share

Source: company's presentation

We have decided to look at British American Tobacco – the company overperformed its peers in nearly all metrics ranging from the share in the market to the profitability and growth — and decide if the up-going chart is a legacy of the past performance or safe investment with an outstanding track record and possibility to catch up with peers at even higher price levels. After looking at the fundamentals, we decide the situation to be quite different from the company of our previous reports – Unilever – not only the company seem to cost its price but we see even more potential to it.

The main trade off in BAT's business is the current financial performance with concerns for the future due to the exposure to emerging markets. We see the sales volumes to decrease in 2015 with the same tendencies as in 2014 — major GDP decrease and FX changes in major markets. In this environment, we see the company managed to improve its expenses, thus surviving through the difficulties. We find performance on the bottom line to be good with margins reaching over 40%, previously a target for the company, although it is generally accepted that the level is just a step for the future. We agree with the company that the current main challenges pose a threat only in the short-term perspective and leave room for improvements, but believe the current market consensus includes sales growth slower than the inflation, thus possible recovery is not required for an argumentation of the current price levels.

Source: company's presentation

One of our constant points of interest is what can investors get out of the investment. In this case, the current dividend yield is around 4.2%, thus investors not only can expect good price performance but also receive some additional cash from the dividends. Similar to other companies we wrote about, we find dividend policy predictable with the payout ratio being in the high 70% levels and good opportunities for future investments with ROIC at around 18-19% in future years vs cost of capital at 8–9%. We highlight it to be a reasonable strategy for the company, and good opportunity for the dividend stock seekers.

Our estimation of the forward P/E 3-year historical range is [15, 22], and the EV/EBITDA is [8, 12]. Our current multiple estimates are 18 and 11, respectively. Although we find the multiple analysis to be a little bit ambiguous in this case, we do not see signs that the company is overvalued at the moment. We find the dividend yield to be a guarantee that the share price will stay at least at the current levels leaving opportunities for upper re-rating. The company has seen its dividend yield to be lower in the past, although the higher levels signaled of profit opportunities in the stock.

Overall, we consider British American Tobacco to be a good investment that will most likely continue its historical performance. We do not see any phenomenal results potential here, but for those looking for safe opportunities with a good dividend yield in addition to the capital preservation, we recommend looking at this case. Our estimation of target price is primarily based on dividend expectations and multiples ranges – we see 7-10% upside supported by the past historical performance of the stock.