British American Tobacco: Get An 8.4% Yield Plus An Upside Catalyst

Shares of British American Tobacco (NYSE:BTI) have declined 16% year to date. However, British American Tobacco is a well-run tobacco firm, achieves consistent profitability and has continual moment in its non-traditional product category that includes its vapour brand vuse... which is seeing strong gross margin momentum due to growing product uptake. Additionally, the new product categories are at the brink of achieving profitability which could lead to an upside revaluation of British American Tobacco’s shares in the near term. Since BAT is currently trading at a P/E ratio of only 7.3X and is expected to generate $49B in free cash flow in the next five years, I believe the risk profile is highly compelling!

Previous rating

I rated British American Tobacco a strong buy in February -- The Market Is Wrong About This 7.2% Yield -- due to strong momentum in new product categories. Considering that the company is seeing exceptionally strong momentum in its vapour category, driven by strong product adoption and pricing, I believe British American Tobacco has considerable earnings surprise potential going forward. I discuss BAT's gross margin momentum, which is significant, as well as the company's compelling FCF guidance. British American Tobacco has guided for ~£40.0B ($49.1B) in free cash flow in the next five years of which I expect a considerable amount to be returned to shareholders.

Vapour products could drive earnings outperformance

British American Tobacco owns the vuse brand which sells vapour products to consumers. Vuse has been instrumental in driving shipment and earnings growth in the non-traditional product category for British American Tobacco and the segment is seeing accelerating product uptake from consumers, especially in the younger demographic. The number of people that adopt vapour products is on a rapid upswing while at the same time the number of smokers is decreasing.

Besides an expansion of the addressable vapour market, British American Tobacco is seeing strong segment gross margin expansion: in the first half of FY 2023, British American Tobacco's vapour segment gross margin expanded 9 PP to 58%, implying that gross margins almost doubled since FY 2020. Strong pricing power as well as shipment growth are the fundamental drivers of this exceptional performance.

Going forward, I expect new product categories to represent a higher share of BAT's consolidated revenues, with vapour products leading the way. In the first six months of FY 2023, new product revenues accounted for 12% of total revenues and I would expect this percentage to gradually increase in the coming years. Product adoption is likely going to increase as well as younger smokers gravitate towards vapour and heated tobacco products. In line with past trends, I would also expect a decrease in cigarette shipment volumes which could be compensated for with new customers in the new product categories.

Vapour products contribute considerably to the revenue momentum that British American Tobacco experiences. In the last twelve months, new category revenues soared 33% to £3.3B ($4.0B). Revenue from new categories increased 29.0% to £1.7B ($2.1B) in the first half of the year while consolidated revenues were up 4.4% to £13.4B $(16.5B). In other words, new product categories, led by vapour, are growing more than 6 times faster than British American Tobacco’s consolidated top line.

Other alternative products include heated tobacco and oral tobacco products. The momentum of vapour products especially, however, is why British American Tobacco is just at the brink of achieving new category profitability (expected for FY 2024). In the first half of FY 2023, the tobacco firm still made a small loss on its new category products, but if vapour momentum continues on its current trajectory, then FY 2024 could truly be a major inflection year for British American Tobacco. The long term goal for BAT is to generate £5.0B ($6.1B) in new category revenue by FY 2025.

Free cash flow return play

British American Tobacco is seeing strong momentum in new category revenues, as shown above, but the real value of an investment lies in the capital returns that investors can expect.

Between FY 2019 and FY 2022, British American Tobacco generated £29.3B ($35.9B) in free cash flow. Of this amount, BAT returned £21.1B ($26.0B) to shareholders as dividends and buybacks. Dividend payments alone totaled £19.1B ($23.4B) during this time.

In total, British American Tobacco returned 72% of its free cash flow to shareholders in the last four years. The company also recently issued a strong free cash flow forecast: British American Tobacco guided for ~£40.0B ($49.1B) in free cash flow over the next five years. Assuming a stable 72% free cash flow-payout ratio, investors can expect the return of £5.8B ($7.1B) in free cash flow annually.

Valuation of BTI vs. rivals

British American Tobacco is the cheapest tobacco company that dividend investors can buy. BAT trades at a P/E ratio of 7.3X which compares favorably against a P/E ratio of 8.3X for Altria Group (MO) and a P/E ratio of 14X for Philip Morris International (PM). I rate both Altria (investment thesis) and Philip Morris (investment thesis) a hold, but given the clear valuation advantage and compelling growth potential, especially in the vapour business, British American Tobacco remains a strong buy for me. I believe BAT could reasonably trade at a P/E ratio of 10X which implies a fair value of approximately $46.

Risks with British American Tobacco

British American Tobacco operates in the tobacco industry which is infamous for lawsuits, escalating advertising restrictions and falling cigarette shipment volumes as the share of smokers in the population is shrinking. While British American Tobacco does have an offset, the development and growth of a new product portfolio, investors must be prepared to continue to see low-single digit top line growth.

While the vapour market is exciting from a growth perspective, the sector may also be prone to expensive litigation. What would change my mind about my investment in BAT is if the company failed to sustain its new category momentum (revenue growth, gross margin expansion) or saw a drop-off in free cash flow.

Final thoughts

British American Tobacco is a well-run tobacco franchise and I believe the downside revaluation that occurred so far in FY 2023 is not justified. Recent results showed that British American Tobacco’s core business is profitable and the company expects positive earnings contributions from its alternative product categories in FY 2024. Vapour gross margins are rising rapidly due to pricing strength and product adoption. Achieving new category profitability would be a milestone achievement for the tobacco company and could potentially result in an upside revaluation. Considering that shares of British American Tobacco are ridiculously cheap with a P/E ratio of 7.3X, I believe the risk profile is even more skewed to the upside than it already was at the beginning of the year!