Even in the most unfavorable scenarios, where non-combustible revenue growth experiences a significant decline, British American Tobacco (NYSE:BTI) can still achieve a remarkable 18.12% internal rate of return (IRR) over the next five and a half years, surpassing the average annual total return of the S&P 500 at 10.15%. Despite the potential challenges, this demonstrates the resilience and strength of BTI as an investment opportunity.
The outlook for British American Tobacco is even more promising as the company diversifies its product mix. Non-combustible options, such as vapor, THP, and modern oral products, offer higher margins, lower taxation, and are less susceptible to regulation compared to traditional cigarettes. Additionally, the non-combustible segment is growing rapidly at a rate of 30-50% per year, while cigarette volumes decline at a rate of 2%. To mitigate any volume declines, BTI can rely on price increases to maintain profitability.
Despite a decreasing trend in cigarette consumption, approximately 19% of the global population still smokes. The legal tobacco industry is anticipated to generate $941.1 billion in global revenue in 2023, with cigarettes accounting for $834.7 billion of this total.
To offset the decline in cigarette sales, major tobacco companies are focusing on higher-margin and safer alternatives, such as vapor, THP, and modern oral pouches. These products present significant growth opportunities, with profits growing at an average rate of 12.3% from 2018 to 2023.
Concerns over the ban on menthol cigarettes in California have raised investor worries about potential bans in other regions. However, studies indicate that such bans have a limited impact on cessation rates, as many individuals remain loyal to their preferred brands.
British American Tobacco is one of the top five global tobacco companies, with approximately 30% market share in the US (compared to Altria’s 50% share). The industry’s high barriers to entry, stringent regulation, and limitations on advertising create a favorable environment for British American Tobacco, enabling the company to generate substantial profit margins.
The company has made progress in reducing its debt-to-EBITDA ratio, which currently stands at 3.67x. With a focus on deleveraging while maintaining dividend payments and reinvesting in the business, British American Tobacco has demonstrated its ability to generate stable cash flow. Strong cash reserves further enhance the company’s ability to meet interest and principal payments. With a free cash flow conversion rate of 90-100% and improving EBITDA margins, BTI’s financial performance is poised for sustained growth.
Currently trading at a multiple lower than its peak during the Great Recession, British American Tobacco presents a compelling investment opportunity. Even without significant improvements in its product mix and multiple expansion, a conservative estimate suggests a target price of $73.64, offering a potential upside of 127%.
Considering the potential for increased adoption of non-combustible products, margin and earnings growth of 6-7% CAGR, and a potential upward trajectory for BTI’s multiple, the future appears even more promising than these conservative projections. By analyzing the EBITDA, NOPAT, and FCF build, it becomes evident that the assumptions behind the 18.12% IRR are intentionally conservative:
Based on these projections, the conservative price target for British American Tobacco is $73.64, offering a significant upside potential of 127%.
Catalysts And Risks
Concerns over the California menthol ban have exerted downward pressure on BTI’s stock. However, as the company continues to meet revenue and earnings expectations, it is likely that its multiple will increase to a range of 12-14x free cash flow. This valuation is reasonable considering BTI’s consistent performance and potential for further margin improvement.
While there are some risks, the tobacco industry typically exhibits stability throughout economic cycles with low beta. A nationwide expansion of menthol bans and high-interest rates may slightly impact the stock’s performance and dividend payments, but these risks are not expected to significantly affect the company’s overall value.
British American Tobacco offers a compelling opportunity for long-term growth. With a projected minimum IRR of 18.12% over the next five to six years, BTI’s stock is highly attractive. While the company has excellent prospects for future earnings growth, its current undervaluation is sufficient to yield exceptional returns. Additionally, the 8.46% dividend yield adds further appeal, and the stability of cash flows and dividends make BTI an ideal core holding in any investment portfolio.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Source : Seekingalpha.com