Interactive Investor

Stockwatch: a £5bn bet on UK tobacco shares  

An American tycoon’s decision to invest heavily in British tobacco stocks implies outstanding value.

An American tycoon’s decision to invest heavily in British tobacco stocks implies outstanding value.

It is pertinent to review the contrarian investment case I made last February for FTSE 100-listed Imperial Brands (LSE:IMB) and Lucky Strike and Dunhill cigarettes maker British American Tobacco (LSE:BATS)

At the time, the share prices were £15.30 and £27.90 respectively. Imperial now trades at £15.25, supported by a 9%-plus yield, and BAT has eased to £27.20 after the US government declared intentions against nicotine and menthol flavouring. 

So, are the fat yields – BAT’s is also over 8% - a case of fair pricing for the risks of a long-term failing industry? 

A remarkable vote of confidence, especially in BAT 

A Cayman Islands billionaire has accumulated a 7% stake in BAT, worth some £4.5 billion, making his investment company the third-largest shareholder. He’s also acquired a £450 million stake in the relatively smaller Imperial. That is a remarkable swipe at “market efficiency”. 

Ken Dart has form as a contrarian investor. A pioneer of vulture funds, he exacted a circa £430 million equivalent pay-out from Brazil’s debt restructuring during the 1990’s. Similar distressed debt plays were on Argentina and Greece, areas that few others would touch. 

As heir of William Dart, founder of Dart Container Corporation (originally in manufacturing and the world's largest manufacturer of Styrofoam cups), he has been very well capitalised to explore high-risk plays. However, given his investment company is worth £4.6 billion overall, his exposure to BAT is massively focused. His only other disclosed stake is in Workspace Group (LSE:WKP), a real estate investment trust. Otherwise, he owns private businesses and property in Cayman. 

From the share price chart, Dart’s buying of BAT has taken place in a circa £25 to £29 range since last summer. He passed the 3% threshold for disclosure last October and has steadily increased.   

Like many stocks, BAT plunged with the onset of Covid-19, then rebounded with monetary stimulus and drifted back from last summer. Yet it has broadly failed to join the vaccines-driven rally from November.  

Is a move to cut nicotine and menthol such a surprise? 

Public policy declarations have weighed on tobacco stocks lately, and BAT derives nearly 45% of revenue from the US versus 14% for Imperial to the Americas generally.  

On 20 April both stocks led the wider market down, with falls of 5% after it was reported the Biden administration wants to reduce nicotine in cigarettes to make them less addictive. Then on 29 April, BAT fell nearly 2% (Imperial barely affected) after the US Food and Drug Administration declared intent to ban menthol flavouring in a bid to improve health among the young, low-income and communities of colour who allegedly are prey to this marketing.  

Apologists for big tobacco say it would take up to a year initially to revise product standards, then a longer rule-making process the companies can disrupt with legal challenges.  

I have some respect for this given that it appeared from the mid-1990’s the industry was certain to be crippled by health litigation from US individuals and states. Years later, just look at their financial strength as shown in the six-year tables below. It has been achieved even with cigarettes in decline, affirming the companies’ claims to be developing successful alternatives. 

Lower nicotine content could also be marketed as “safer”, quite like low-sugar food sales have surged as people feel less guilty indulging.  

That BAT and Imperial have rebounded from lows of £27.50 and £14.95 amid such news from the Biden administration suggests it may be less relevant in the medium term. Yet I would not under-estimate Biden’s intent to address public health, inequality and climate change. 

“We believe these actions will launch us on a trajectory toward ending tobacco-related disease and death in the US,” he said. Post the Trump years, it is easy to be complacent that business can get away with doing what it wants. The risks may still be (more than) priced in. 

Strong 2020 results despite shock and disruption of Covid-19  

Both companies have achieved modest single-digit percent progress in key variables, although BAT’s free cash flow is up over 10% and Imperial’s by 27%, which is the key for dividends.  

Consensus forecasts are for BAT to pay out 217p a share this year in dividends, representing 3% growth, and 230p in 2022, implying an 8% yield, rising to 8.6% based on a current stock price of £27.20. Earnings cover would be over 1.5x and the strength of free cash flow implies cover around 2x – assuming forecasts are dependable. The sheer strength of cash flow and its record helps de-risk them though. 

Imperial is projected for sub-2% dividend growth to 140p a share this year and 143p next, implying a 9.2% yield, rising to 9.4% with the market price currently £15.25. Earnings cover is implied over 1.7x and on the basis of 2020’s bumper free cash flow per share of 372p, cover would be over 2.6x. 

British American Tobacco - financial summary            
Year-end 30 Dec 2015 2016 2017 2018 2019 2020
Turnover (£m) 13,104 14,130 19,564 24,492 25,877 25,776
Operating margin (%) 34.0 32.2 151 38.2 34.8 38.1
Operating profit (£m) 4,453 4,554 29,547 9,358 9016 9,820
Net profit (£m) 4,290 4,648 37,485 6,032 5,704 6,400
IFRS3 earnings/share (p) 230 249 1,360 260 247 273
Normalised earnings/share (p) 234 239 251 284 316 328
Operating cashflow/share (p) 253 247 261 449 393 426
Capital expenditure/share (p) 32.3 36.1 47.7 41.1 35.6 32.9
Free cashflow/share (p) 221 211 213 408 357 394
Dividend/share (p) 154 169 100 195 203 210
Covered by earnings (x) 1.5 1.5 13.6 1.3 1.2 1.3
Net Debt (£m) 15,003 17,276 45,649 44,259 42,243 40,088
Net assets per share (p) 263 439 2,649 2,853 2,786 2,732

Source: historic company REFS and company accounts

Imperial Brands - financial summary            
Year-end 30 Sep 2015 2016 2017 2018 2019 2020
Turnover (£m) 25,289 27,634 30,247 30,066 31,594 32,562
Operating margin (%) 7.9 8.1 7.5 8.0 7.0 8.4
Operating profit (£m) 1,988 2,229 2,278 2,407 2,197 2731
Net profit (£m) 1,691 631 1,409 1,368 1,010 1,495
IFRS3 earnings/share (p) 177 66.0 147 143 106 158
Normalised earnings/share (p) 214 94.3 178 150 163 187
Operating cashflow/share (p) 287 330 320 323 337 420
Capital expenditure/share (p) 503 17.1 23.2 41.2 44.6 47.4
Free cashflow/share (p) -216 313 297 282 293 372
Dividend/share (p) 141 155 171 188 207 138
Covered by earnings (x) 1.3 0.4 0.9 0.8 0.5 1.2
Net Debt (£m) 12,165 12,664 11,925 11,220 11,348 ######
Net assets per share (p) 557 554 595 605 519 515

Source: historic company REFS and company accounts

Recent outlook statements affirmed projections 

At BAT’s 28 April AGM, the chairman said trading in the current financial year has been “robust”, and he affirmed 2021 guidance for constant currency revenue growth of 3% to 5% despite global tobacco industry volume down around 3%.  

After nearly 6% of 2020 revenues derived from lower-risk “new category” products, with 15% intrinsic growth over 2019, “we are on track to meet our £5 billion new category revenue ambition by 2025.” Strong growth also in non-combustible products leads to the claim of “transforming into a high-growth, multi-category consumer goods business, with a purpose to reduce its health impact”. 

Mind that with the US dollar remaining weak, there is “a continued foreign exchange headwind of around 7% on full-year adjusted EPS growth”.  

Imperial’s last trading update was 30 March in respect of its first-half year from 1 October 2020, citing a “good” start to the year, with the business on track to meet full-year expectations of low to mid-single digit operating profit growth. This assumes an adjusted and constant currency basis, likewise the projection of at least 1% first-half net revenue.   

Macro context could help prompt mean reversion 

I suspect Ken Dart is mindful of the risk to growth stocks; that it might not take much capital re-allocation to spur a new belief that tobacco represents value. 

In the last few days, Goldman Sachs has warned that metals and oil prices will soar as emergence from lockdowns creates demand surges. Last Saturday, Warren Buffett told his shareholders “We’re seeing very substantial inflation”. Even if the Federal Reserve does nothing to raise interest rates, markets may start to price that risk in – which in equities implies a shift from “growth” to “value” investment styles. 

Dart’s stakes have been accumulated quietly and he says nothing. Yet they are a loud raspberry at the market’s sense that big tobacco cannot sustain its financial performance. Also that fat dividends are liable to be (more than) offset by capital erosion in the longer run. Clearly, he reckons BAT offers such a compelling value, there is hardly any point in diversifying.  

Take your own ethical view on tobacco, but as for financial analysis of BAT and Imperial I retain my stance: Buy

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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