British American Tobacco: Stock price falls on irrational signals (NYSE:BTI)

Despite the very high dividends, British American Tobacco plc (New York Stock Exchange: BTI) has been a major disaster for shareholders for a long time. The company is investing aggressively in cannabis and has outlined its plans. Listing America’s combustible brands on signs management now fears the end of its main business line. My investment thesis is slightly bullish on stocks after an irrational crash by the end of 2023.

strange signal

The company recently announced additional investments. organization chart (OGI) Despite the terrible investments in March 2021. BTI discusses its goals for a smoke-free world, but cannabis puts the company right back into its consumer base that smokes regularly.

BAT plans to invest an additional 74 million pounds (CAD 125 million) between January 2024 and January 2025 and increase its equity position from 19% to 45%. The original investment was £126. The stock is currently trading at C$2.25 after an uptrend following increased investment in BAT.

BAT must find alternatives to cigarettes, which are becoming illegal around the world. Britain is trying to enforce laws that would prevent 14-year-olds from being able to legally buy cigarettes under a planned smoking ban.

The tobacco company just wrote off a massive $31.5 billion worth of its U.S. cigarette brands. BAT plans to completely write off $80 billion worth of these brands from its balance sheet over the next 30 years, an announcement that sent its share price crashing last December.

Currently, BAT gets only 12% of its sales from new product categories. This suggests that the company isn’t sending much of a signal to shareholders by reducing its valuable U.S. brands to zero by 2053. Needless to say, new categories of vapes and menthol products are not as closely scrutinized.

In fact, the CEO used this statement in a recent conference call with analysts to completely refute the record that he does not believe cigarettes will disappear during this period.

I’m not saying that combustibles and cigarettes will disappear from America in 30 years. I really don’t believe that. But we cannot justify that the value of those brands is equivalent to the numbers we have on our balance sheets today.

Either way, BAT made a brutal investment in Organigram in an attempt to enter the cannabis space, which could help transform the business away from combustible substances. During this period, the original investment for 2021 has fallen by more than 50%. Additionally, BAT has invested in Canadian cannabis companies that do not have access to the large cannabis market in the United States, reducing many of the benefits of investing in cannabis.

The combined moves should raise questions about whether management is making sound judgments about the future. Despite forecasts for low single-digit organic growth and a target for 2024 revenue growth of about 3%, the stock collapsed.

Since the dividend yield is around 10%, the stock price should not fall to a new low. BAT now only trades on a 6x EPS target. With 4% EPS growth from a base EPS of $4.67 in 2023, the company will achieve EPS of $5.25 in 2026.

At present, BAT expects new categories of non-combustible products to account for 50% of sales by 2035. More than a decade on, BAT will still remain highly dependent on flammable products despite all its plans to transform its business.

Dividend Struggle

BAT is a prime example of the difficulties companies face paying large dividends while carrying large debt balances. It’s not a huge shock, so the market hasn’t really rewarded a stock that doesn’t focus more on paying down debt than growing dividend payments.

The legacy tobacco company increased its dividend payout from £4.6 billion in 2019 to £4.9 billion in 2022, while its leverage ratio remained relatively high at 3x. To make matters worse, management was spending more than $1 billion per year on stock buybacks during that period.

While this may seem shareholder-friendly, the best course of action for shareholders of companies struggling to grow is to reduce debt. The only way a company producing FCF can get into trouble is if it suddenly sees its cash flow deteriorating while its debt grows due to poor capital allocation planning.

BAT still has net debt of £37.259 billion and the company has surprised markets by suggesting its valued brand has a limited future. In such a scenario, BAT would have trouble repaying its debt and naturally the markets would panic.

A simple solution is to reduce interest expenses to pay down debt and increase cash flow. Share buybacks can occur even in scenarios where debt levels are much lower and earnings are weak, when the risk of future default is significantly reduced.

BAT still offers great discounts. Philip Morris International (afternoon) and Altria (MO) due to currently limited non-combustible revenues and the company threatening the market. Philip Morris is also expected to grow faster, warranting a higher forward P/E multiple, although its growth rate may not be large enough to cover its current large valuation gap.

A lower dividend payout ratio in the 65% range would be another boost for BAT, but only after debt levels have been reduced, well below the current target of reaching 2.5x EBITDA before adjusting the capital allocation strategy. The company plans to utilize free cash flow for share repurchases and additional M&A transactions. According to the proposal, BAT will consider such a plan once its leverage ratio reaches approximately 2.5 times EBITDA, but the company should consider pushing towards a lower leverage target.

takeout

The main takeaway for investors is that BAT is relatively cheap and its high dividend yield of 10% will attract investors. But management needs a better message to avoid surprising the market again. Irrational investment in Canadian cannabis and declining value of American brands sends an unfair signal to businesses. The reality is that slow growth will reward investors over time if the company correctly allocates its cash flow to chasing bad investments instead of simply paying down debt. The same applies even to treasury stocks.

Yields as high as 10% typically indicate weakness, but BAT has taken some unnecessary steps that make the company look weak. If the company starts making better decisions, the stock will likely provide solid returns in the future.