A very generous dividend makes this blue-chip one to hang on to despite potential problems on the horizon, argues analyst Edmond Jackson.
Have Anglo-Saxon stock markets become addicted to share buybacks? Perhaps the most frequent regulatory announcement nowadays is “Transaction in Own Shares” irrespective of whether the market is in greed or fear mode. Decades ago, buybacks were resorted to occasionally when a stock was depressed, given they were seen as management lacking useful investment projects.
In relatively recent years, however, they seem to have become another prop – along with interest rate cuts and quantitative easing – where investors salivate at the news, stocks will get squeezed higher.
How else to explain an early 5% drop yesterday in reaction to the 2022 results from British American Tobacco (LSE:BATS), in which the only “negative surprise” was the financial review. After £2 billion was spent on buybacks from last February to December, BAT dared to say balance sheet strengthening would be its current priority – with interest rates rising on around £40 billion net debt – while reassuring investors that buybacks would be kept under consideration for later this year.
Personally, I see the key near-term risk for this stock as being a US Menthol cigarette ban, given BAT derives some X% of operating profit this way. Yet perversely, it could be an opportunity for fresh buyers due to legal challenges delaying its implementation for some years, and the stock is already yielding 8%.
Possibly, BAT has been out-of-favour this year amid a frenetic rush for growth and higher-risk cyclical stocks, in the belief that interest rates have peaked and a recession may be avoided. Its drop to 2,950p yesterday was a capitulation given it steadily won back over half its losses to 3,018p currently. This 2,950p level has also been seen as a level of technical support.
President Biden turns tax screw on buybacks
Biden’s State of the Union address last Tuesday entertained raising from 1% to 4% a tax on share buybacks introduced last August. And, as if buybacks have become a form of market abuse – such as to boost earnings per share, to which executive bonuses are often linked – the White House may push for the tax to be gross rather than net of any shares issued for employee pay and to finance takeovers.
Quite what will happen given Republicans control the House of Representatives is unclear, but it underlines how critics judged the 1% tax as insufficient to deter rampant spending on buybacks. The Democrats want to close any loopholes unnecessarily beneficial to corporations and the wealthy.
Another interpretation of “buybacks in the dock” politically is manifesting excess money creation and ultra-low interest rates persisting too long. This made managers lazy, thinking why not just gear up the balance sheet and appease investors with yet another buyback programme? Once a majority of firms are manipulating their equity this way, others have to keep up.
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Yet BAT’s pausing to strengthen its balance sheet, as a “big beast” company, could signal a sea-change where more businesses realise they need to cut debt and exact better growth in tough times.
It said: “Given our incremental investment plans in 2023 to further accelerate our transformation, and in light of the uncertain macro environment, higher interest rates, outstanding litigation and regulatory matters, the board has decided to prioritise strengthening the balance sheet. This will provide greater business resilience while continuing to support future financial agility, as we aim to reduce leverage more quickly towards the middle of our target 2-3x corridor...We strongly believe that share buybacks have an important role within our capital allocation framework, and we will continue to keep it under review as we progress through the year.”
You would barely think such words could affect a £68 billion stock, yet BAT otherwise was in line with expectations.
Broadly flat numbers in inflation-adjusted terms
I am being quite harsh as the reported numbers are compromised by various one-off items, hence operating profit edged up 2.8% to £10.5 billion, albeit by 11.3% on an adjusted basis - on revenue up 7.7% to £27.7 billion, despite a 1.5% negative foreign exchange headwind.
Constant currency revenue growth in the order of 3-5% is guided for 2023, which affirms BAT in the “value/income” category, hence subject to shifting fashions of capital allocation versus “growth”.
Having invested over £2 billion in so-called new categories like vaping, this segment achieved revenue growth of around 40% to near £2.9 billion, albeit with a £366 million operating loss. Management reiterates confidence in achieving profitability in 2024 and £5 billion sales by 2025 – but obviously, this is more about substituting declining tobacco sales (also potentially menthol cigarettes) in years ahead.
Reported diluted earnings per share eased 1.3% to 292p but rose 12.9% to 371p once normalised. Net cash from operations rose 7.0% to £10.4 billion, helping the dividend up 6.0% to 231p in respect of the full year (than when actually paid).
Long-term debt is up 6% to £38.7 billion and near-term debt by 10% to £4.4 billion versus cash of £3.4 billion. While net finance costs were not onerous, they took 15.6% of operating profit – which needs containing for a big company challenged for growth.
In shareholder value terms, the board is therefore right to pause buybacks, yet it appeared the market threw a tantrum, like a child addicted to sweets instead of wanting dinner.
|British American Tobacco - financial summary|
|Year-end 31 Dec||2015||2016||2017||2018||2019||2020||2021||2022|
|Turnover (£ million)||13,104||14,130||19,564||24,492||25,877||25,776||25,684||27,655|
|Operating margin (%)||34.0||32.2||151||38.2||34.8||38.1||39.8||38.2|
|Operating profit (£m)||4,453||4,554||29,547||9,358||9016||9,820||10,234||10,573|
|Net profit (£m)||4,290||4,648||37,485||6,032||5,704||6,400||6,801||6,666|
|Reported earnings/share (p)||230||249||1,360||260||247||273||289||293|
|Normalised earnings/share (p)||234||239||251||284||316||328||326||307|
|Operating cashflow/share (p)||253||247||261||449||393||426||423||442|
|Capital expenditure/share (p)||32.3||36.1||47.7||41.1||35.6||32.9||32.4||29|
|Free cashflow/share (p)||221||211||213||408||357||394||391||413|
|Covered by earnings (x)||1.5||1.5||13.6||1.3||1.2||1.3||1.3||1.3|
|Return on total capital (%)||19.8||16.3||23.6||7.2||7.4||8.0||8.4||7.8|
|Net Debt (£m)||15,003||17,276||45,649||44,259||42,243||40,088||35,933||39,114|
|Net assets per share (p)||263||439||2,649||2,853||2,786||2,732||2,924||3,371|
|Source: historic Company REFS and company accounts|
How damaging might a US menthol cigarette ban be?
A US menthol cigarette ban is really the crux for BAT given menthol constitutes nearly a quarter of operating profit. Such a move by the US Food and Drug Administration could hit the stock this year but take some years to actually implement given legal challenges.
Meanwhile, BAT says it expects to generate around £40 billion free cash flow over the next five years, a timescale over which the loss of US menthol revenue might not be significant. Currently, the dividend pay-out is covered nearly twice by free cash flow.
Quite whether debt reduction plans are included in this five-year projection is unclear, but with the annual dividend costing near £5 billion in the last two years, mid single-digit per cent dividend growth is effectively underwritten.
I suggest a stock drop would likely bring out income seekers (also traders anticipating them) similarly as the price has now recovered to near 3,050p. Interest rates are not going to jack up much further in a worse-case inflation scenario, as central banks know this would mean a slump. There are scant low-risk choices for income.
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At 3,035p currently, the prospective yield is 8.1% this year rising to 8.7% based on consensus for 2023/24 pay-outs. The market is justifiably pricing for regulatory action contra-menthol, which any BAT holder should be steeled for.
But like the health-based US litigation awards that culminated in a Master Settlement Agreement nearly 25 years ago, I suspect big tobacco companies are more likely to adapt than die – and BAT still has a 38% operating margin.
Certainly, health issues manifesting around vaping – seen as the marketing way forward towards younger generations – need watching, as this could also mean tougher regulation.
But all considered, and if you find the ethics of investing in the smoking industry acceptable, a case remains for BAT as a portfolio building block – especially within an ISA or SIPP, where dividends can accrue tax-free instead of being exposed to a government raid on “wealth”.
Defensive stocks may resume favour
Perceived growth stocks dramatically outperformed defensive sectors in January, but sentiment can easily shift. Even Cathy Wood, once a feted evangelist for high-priced US growth stocks, has a latest video – warning of catastrophic consequences “worse than recession” from the Federal Reserve’s monetary tightening.
Be diversified, to cope with varying scenarios. Hold.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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