This is my attempt at a quality research report. I see more and more on Reddit, this sub or others, that there is a lack of FA -only TA. Or, like in r/investing today complaining that this sub is all backwards looking and focuses on past performance. This is my answer.
Let me know suggestions or how I can improve. I had some graphs in the original PDF I mad, but left them out here because no images are aloud. Thanks for reading!
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BTI Fundamental Analysis
Price Target $50 – 28% Discounted
OUTLOOK
It is no surprise that e-cigarettes are fundamentally changing the tobacco industry. E-cigs have been around a while, but there is apparently less loyalty to certain old guard brands. Consumers are more and more health conscious, yet most likely conventional tobacco products will still dominant the industry for the next decade. Still, Big Tobacco companies are still investing into the new forms in order to win over customers.
As of today, British American Tobacco has a very well hedged position in the new forms of tobacco consumption, thus preparing itself for a shift in consumer demand. Their Vype brand is becoming more and more popular in the United Kingdom, and they recently acquired Reynolds which gives them access to Vuse. In 2020 British American Tobacco spent GBP 121 million on research and development, yet that is much smaller than their competitor Philip Morris Tobacco who spent GBP 356 million last year. British American Tobacco (BAT) is also lagging in major new categories. In traditional tobacco products, BAT has taken 6% in Japan last year, but still not as much as Philip Morris. Nevertheless, BAT is determined to become more competitive and has set a target of GBP 5 billion of revenue generated from next generational products by 2025. Vaping has lower barriers to entry and lower profit margins than traditional tobacco by fire, therefore revenue growth might not be the key growth performance indicator.
Notably, British American Tobacco has acquired Reynolds American to increase their stake in the combustible tobacco business. Reynolds American owns the brand Newport which still has a strong presence and consumer loyalty compared to others. Their volume is declining slower than others in the US and Newport’s are priced competitively. This is probably the major reason for recent weakness in British American Tobacco’s stock price as increased fears of menthol regulation and the strategic acquisition of Reynolds exposes BAT to the menthol category even more.
PRICE TARGET DRIVERS
My price target estimate for British American Tobacco ($BTI) is $50 which implies a earnings multiple of 16 times, 12 times enterprise value (EV/EBITDA), a free cash flow yield of 7%, and a dividend yield of 5%. For the most part, these estimates are mostly inline with BAT’s comparable of Philip Morris and Imperial Brands and the historical valuations that I pulled. I believe that this is appropriate given BAT’s positioning in traditional and next generational tobacco.
The price target will all depend on BAT’s sustainability of the operating margins for the traditional combustible business, as I think that is what they are best positioned for. I assume a 1% sales growth which is below a consumer staples sales growth of 4% and below BAT’s comparable, Philip Morris. I am also assuming a volume decline over the next 5 years of 3%. Lastly, I believe the push to next general products, including vaping, will reduce the profit margins. I assume EBIT (earnings before interest & taxes) is 39.5%, which is lower than last year.
SUSTAINABLE COMPETITIVE ADVANTAGE
British American Tobacco holds a strong franchise in the tobacco industry, which is formed by their intangible assets and cost advantage. Obviously, government regulations in the tobacco industry have made the barriers to entry almost impossible. Consumers are also continuing to be brand loyal which is creating another intangible asset for BAT. Lastly, enormous tobacco conglomerates have the advantage of scale.
Intangible Assets
Nicotine is an addictive substance which is hard to quit. Data from Tobacco Atlas states that more than 60% of smokers want to quit and as much as 42% have tried in the past 12 months. Nevertheless, globally smoking rates are barely declining which suggests that smokers have failed to quit. Also, academic research that I’ve read shows that failed attempts at quitting might be tied to premium price and brand loyalty. British American Tobacco has a very balanced cigarette portfolio, arguably one of the most balanced of all the major players. Their premium category generates around 25% of revenue, 33% in mid-tier categories, and the remainder in the affordable category.
Government regulation combined with the fact that nicotine is addictive give BAT a competitive advantage as it reduces competition on prices. One example is that mass tobacco advertising is banned in most markets. New entrants into the market would have a hard time gaining attention. Also, the lack of marketing prevents brand switching and indirectly creates loyal customers. Compared to other industries, big tobacco doesn’t spend near as much as others in advertising. Only a mere 1.5% of sales is spent on marketing. However, it is possible that they will increase this as the next generation products, i.e., vaping is increasing in popularity. Furthermore, Point-of sale display bans don’t allow consumers to compare pricing and incentivizes brand loyalty. Therefore, manufacturers aren’t engaging in a promotional price competition. Another example of barriers to enter the tobacco industry is the US FDA. The marketing of new tobacco products is subject to FDA approval, which is not easy to get.
Brand loyalty remains loyal in the tobacco industry and I do not see any major changes happening in the near future. This is due to challenges to enter, regulatory barriers, and restrictions on marketing. Consumer brand loyalty benefits premium tobacco products more and puts British American Tobacco right in the middle of all of its competitors, such as Philip Morris and Imperial.
Cost Advantage
British American Tobacco’s business is very scalable. The more volume of cigarettes that BAT produce, the cheaper the production cost is. In 2020, estimated production costs of a pack of BAT’s cigarettes were $0.57 on a volume of 629 billion sticks. This is in the middle of their competitors, PMI and Imperial.
Good Sustainability
Although counterintuitive in a declining industry, I believe that the British American Tobacco price target of $50 if appropriate because it is likely that the company will continue generating returns on invested capital for the foreseeable future. The sustainability of profitability and returns on capital will depend on future increases in tobacco prices that will follow inflation and declining demand. Based on past examples it seems that this is likely. In 2011, Australia implemented a series of anti-cigarette measures which led to more taxes being placed on tobacco. Over 6 years, the retail prices of cigarettes doubled and only led to a 3% drop in the smoking rate in the country. According to the World Health Organization, a pack of cigarettes now costs roughly $26 in Australia which is well above $17.80 in the UK, $6.50 in the US, and $5.50 around the globe. Assuming this example is applicable, there is plenty of room for Big Tobacco to raise their prices in order to continue being profitable. Therefore at 4% real pricing, incorporating a 2% global inflation, it might be two decades before British American Tobacco will not be able to generate rent.
However, BAT’s recent acquisition of Reynolds American has lowered its return on invested capital generation (ROIC), and I would expect the company’s weighted average cost of capital (WACC) to remain thin. Now that BAT paid $49.4 billion for the 57.8% of Reynolds, it will be limited going forward for new acquisitions. However, I believe that BAT will still be able to create excess returns on capital.
CAPITAL ALLOCATION
Balance sheet leverage increased when British American Tobacco acquired Reynolds American. In my opinion, the deal created limited value. BAT paid 10 times enterprise value/EBITDA for the company, which lowered their ROIC. However, acquiring the product Newport and staying on top of the competition will provide future benefits, similarly in 2011 when BAT acquired Protobacco for 11 times EV/EBITDA.
Management has also been somewhat of a problem for BAT. In April 2019, Jack Bowles, former COO of the international business, replaced by Nicandro Durante as CEO. It is still uncertain how Bowels plans to turn the business around. Now with the growing demand for next generational products and with that comes lower profit margins, I would want BAT to focus on profitable growth vs revenue growth.
Submitted July 25, 2021 at 04:26AM by prostockadvice https://ift.tt/3rzZvPF
