British American Tobacco: Let’s Ask Benjamin Graham (NYSE:BTI)

Irene Puzankova BTI stock and Graham’s wisdom on defensive stocks My last article on British American Tobacco (NYSE:BTI) (OTCPK:BTAFF) was published a bit more than 3 months ago on April 4, 2024. At that time, I rated the stock as a strong buy. The stock price was $29.67, translating into a yield of 10% and a P/E ratio of only 6x. I argued that this is a good opportunity based on the following considerations: BTI’s absurdly high yield and low P/E suggest either a dividend cut or permanent stagnation. But I see the exact opposite scenario. I see robust cash flow, strong financial strength, terrific profitability, and healthy growth potential. It is thus a compelling opportunity for contrarian investors. Seeking Alpha Fast forward to now, the stock indeed delivered a solid quarter with a ~9% total return, slightly beating the market’s 8.27% rally (one of the best quarters for the overall market). In the meantime, the company also released its 2024 First Half Pre-Close Trading Update. With the updated financials and stock price change, I feel an updated assessment of the stock is in order. Moreover, unlike my last article which focused more on its dividends, I want this update article to provide a more holistic view covering several topics mentioned in the 2024 H1 trading update. Given the amount of information I wanted to cover, I had to think about how to keep the writing structured and organized. In the end, I decided to follow the framework developed by Benjamin Graham on selecting defensive stocks. I think the framework is very fitting for a mature tobacco company. At the same time, the framework also touches on various aspects of the business including dividends, growth potential, valuation, etc. After this holistic evaluation, my conclusion is that BTI is an excellent fit to the framework, and thus I maintain my strong buy rating. BTI stock: the basics The framework is organized from Graham’s classic entitled The Intelligent Investor. It had been detailed in my earlier article, and a brief recap is below for ease of reference. Is the company large, prominent, and conservatively financed? The specific metrics to look for are stable financial strength, consistent capital structure, and a long record of continuous dividend payments. Especially the dividend record. Graham emphasized countless times the importance of dividend records – for good reasons. In his own words, he thinks “a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company’s quality rating”. Has the company demonstrated an adequate level of Earnings Growth in the past? For defensive investors, growth is not the key and “adequate” is enough. In Graham’s mind, a minimum increase of at least one-third in per-share earnings in the past ten years is adequate enough. Finally, are the valuation multiples moderate? As a value investor to the core, he also recommended a series of methods for investors to gauge the price they should pay. Many of the criteria in this check are easy to check off. So I will quickly go over them in this section and leave the more in-depth discussion to the remainder of the sections. British American Tobacco is one of the world’s leading consumer goods companies. After acquiring the remaining 48% stake in Reynolds American in July 2017, it became the largest publicly traded tobacco company in the world. The company engages in the manufacture, distribution, and sale of tobacco products, including cigarettes, vapour, tobacco heating products, oral tobacco, nicotine goods, etc. In terms of financial strength, BTI’s debt ratings are in the upper medium end of the investment grade by all rating agencies, with either a stable or positive outlook. As such, I consider it is safe to conclude that BTI is a large, prominent, and conservatively financed company. BTI debt ratings Its dividend record and safety are the focus of my last article, so I won’t delve into this topic too much and will just invite readers unfamiliar with its dividend data to read it. The conclusion is that BTI’s dividend record also meets (actually exceeds) Graham’s requirements. BTI stock: growth outlook Now, let’s move into the more involved topic of growth. Graham’s minimum growth is at least one-third in EPS in the past 10 years, translating into an annual growth rate of 2.9%. BTI’s past growth rates exceeded this minimum requirement. It has grown its EPS at a CAGR of 3.0% in the past 10 years and 4.0% in the past 5 years. However, the future growth outlook is cloudier, as reflected in the numbers from its 2024 H1 trade update. Sales in the second half of the year were down modestly compared to the previous-year tally, although organic sales on a constant currency basis were up 3%. The key dynamics here is the battle between the decline of cigarette volumes and the growth of its new categories. For H1 2024, the top line continues to be pressured by lower cigarette volumes, which decreased roughly 8% last year. However, the New Categories group, which includes vapor, tobacco heating, and modern oral goods, continues to post strong results. Organic sales in that segment rose 21% in 2023. Looking ahead, management expects global tobacco industry volumes to decline by 3%, mainly due to weakness in the U.S. and Indonesia. However, the company anticipates low-single-digit organic sales growth, driven by ongoing strength from New Category products, particularly Vuse and Velo. The former product is the global market leader in the vapor category, which is the fastest-growing alternative to traditional cigarettes. Velo is one of the leading modern oral brands in a rapidly growing category with the lowest toxicant profile of all New Categories. All told, the market expects EPS to rise at a low-single-digit rate. More specifically, the chart below shows the consensus EPS estimates for BTI stock in the next 3 years. As seen, the market expects its EPS to grow at a compound annual growth rate (CAGR) of 3.2% over the next 3 years, still higher than Graham’s minimum requirement. Seeking Alpha BTI stock: valuation Now onto valuation. As aforementioned, Graham recommended a series of methods for investors to gauge the price they should pay. For example, he suggested that the P/E for a defensive stock should be around 8.5 plus 2x the growth rate (which is now known as the Graham P/E). And the table below shows my calculation of the Graham P/E for BTI. As you can see, based on the 3.2% annual growth rate projected by consensus, the Graham PE/ for BTI should be 14.9x (8.5 + 2 * 3.2). This is higher than the current market P/E of 6.70x by more than 100%, which suggests that the stock is very undervalued according to Graham’s methodology. Author The table also shows my projection of BTI’s Graham numbers based on its 2024 FW financials. The Graham Number is a measure of intrinsic value based on EPS and book value (“BV”). It is calculated as the square root of 22.5xEPSxBV because of the following considerations. By taking the BV into consideration, the Graham number thus complements the typical P/E ratios and accentuates Graham’s philosophy of playing defensive. In general, Graham cautions against paying a price of more than 15x times earnings or more than 1.5x times the book value (“BV”). However, a PE multiple above 15x could be justified if the P/BV ratio is lower than 1.5x. And vice versa. And as a result, the Graham number considers both the 15x PE limit and the 1.5x P/BV limit. More specifically, the Graham number is the square root of A) 22.5 (which equals 15 times 1.5), B) the EPS, and C) the book value. As seen, my estimate of the Graham number for BTI is about $56.6, which shows a similarly large discount (about 44%) from its current market price as the Graham P/E. Other risks and final thoughts Besides dwindling cigarette volume, investing in BTI (or its tobacco peers) also comes with other inherent risks. The entire industry faces increasingly more stringent health concerns and stricter regulations. Additionally, all tobacco companies are challenged by the development and uncertain regulatory landscape surrounding next-generation products, like e-cigarettes, which are positioned as potentially less harmful alternatives but raise their own health questions. Altria’s failed experiment with JUUL provides a recent illustration of such a risk. For BTI specifically, there are some additional concerns. Compared to some of its peers (such as Altria), BTI derives a significant portion of its revenue from emerging markets in Africa and Asia. These markets can be more volatile due to political instability, currency fluctuations, and potential changes in regulations specific to those regions. A more remote risk in my mind involves cannabis. Unlike some peers who have ventured into cannabis partnerships, BTI has not yet publicly embraced cannabis to my knowledge. Cannabis-related products could potentially be a high-growth market segment, and BTI could be playing catch up if cannabis use becomes more mainstream. Despite the above declining smoking rates and regulatory hurdles, my verdict is that BTI presents a compelling buy opportunity. The stock checks off all requirements in Graham’s framework for picking defensive stocks. The stock’s valuation sits at a significant discount to the Graham P/E or Graham number. Admittedly, the growth curve is uninspiring (around 3% per annum) and there could be regulatory hurdles for the expansion of its new categories. However, I think these risks are already compensated by the valuation discounts. Finally, the high dividend yield (close to 10%) provides attractive income and downside protection.

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