British American Tobacco Q2: Should Suspend Dividend (NYSE:BTI) – Looking for Alpha | Vette Leader

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British-American Tobacco (NYSE:BTI), hereinafter referred to as BAT, had a good year, characterized by a decent outperformance compared to the main market, which on the other hand suffered for various reasons. The stock has continued to rise than 10% in dollar terms and more than 20% in sterling terms, and has paid a whopping dividend of about 7% over the last 12 months.

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That means BAT has done an outrageous job of protecting its investors’ money from inflation, which is what you should expect from a company like this.

The results of the first half of the year

BAT published its results for H1/2022 a few days ago. They were negatively impacted by a number of one-off events, notably a £450m provision for a potential fine over an alleged sanctions breach and a £957m non-cash write-down of the value of the company’s Russian operations, the is now for sale. Adjusted for these items, results were mixed, with total revenue up in the mid-single digits and diluted earnings per share up about 9% year over year. Sales from the new category increased by 45% and now account for about 10% of total sales. This segment’s losses narrowed significantly to £222m in the first half and should reach profitability sooner than expected (2025).

All in all, in the coming years the company will gradually move away from the combustible tobacco products business and focus on the development of new product categories: it will not be an easy path, since the profitability of the new products is likely to be lower compared to the traditional tobacco business: the latter will meanwhile also cannibalized by the new product trends. The big negative factor in the first half was a massive drop in US cigarette volumes (-13.4%), which the company attributed in part to destocking. However, the number seems too bad not to raise concerns and the market confirmed this, perhaps punishing BAT shares a little too much: -7% in the five days after the results were released. Aside from the business model, which makes sense to me as I remain convinced that the move to NTPs will eventually be successful and BAT manages to create a strong moat around its products, it’s more the debt burden that freaks me out as investor worried. The British tobacco giant borrowed a lot a few years ago to acquire all of America’s Reynolds in a huge $49 billion deal. In hindsight, that decision was probably not wise as we now see US volume falling rapidly and on the other hand debt is still piling up on BAT’s balance sheet, although admittedly it is steadily being reduced. With a net debt/EBITDA ratio of about 3 this year, management has been confident enough to embark on a buyback program in addition to the generous dividend that returns shareholders nearly 7%. You may be right about that as the average debt maturity is almost 10 years and 90% is committed while cash flow generation is obviously very strong with a forecast of £40bn free cash flow over the next 5 years, which btw it is is also the same as the company’s net debt. However, we must not overlook the fact that we are currently in a hyper-inflationary environment, which should weigh on the company’s debt management: Indeed, net debt has increased by 12% over the last six months, although it is still on the decline year-on-year.

Company report

company report

A creative way

In the current situation, I don’t think it should be considered heresy to consider a dividend cut. I realize that much of the company’s reputation rests on its status as a reliable dividend payer, and many BAT shareholders rely on it. However, it is prudent to move quickly on deleveraging now, and delaying it could have long-term negative consequences. For example, if inflation finally spirals out of control, the cost of paying off the debt becomes too high for the UK company. Then a dividend cut would not be an option, but a necessity.

So it’s better to be ahead of the curve and do it now when most things are under control. I know that probably the majority of readers here would argue that BAT manages inflation very efficiently, but I don’t think that’s entirely true. As we just saw over the last quarter, the company has acted on prices to offset US inflation, but has only managed to deliver modest annual nominal growth (see chart below).

Company report

company report

It has not been able to keep up with the nearly double-digit rise in inflation over the past 12 months. The point is that BAT (and indeed the other tobacco companies) use price increases in their traditional business to counter the steady decline in their tobacco volumes. It is unrealistic to think that they could continue raising prices to offset inflationary pressures and deliver real growth.

Phillip Morris

Phillip Morris

It is important to note in this context that BAT should not suspend its buyback programs but should extend them. If a dividend cut (or full suspension) resulted in a significant drop in the company’s stock price, a buyback would be a very efficient way to add value. A few years down the line, it could start paying a nice dividend again, possibly much bigger than it is now.

bottom line

British American Tobacco is probably the ideal company to own in this intricate web of history. Its business is resilient to major disruptions in the economy and financial markets. And yes, British American Tobacco is an inflation game, albeit to a lesser extent than many believe: plus, the stock is cheap! Still, there are some risks to consider. First and foremost is the debt burden, which could threaten the company’s financial stability if interest rates rise significantly in the near term (although the long average maturity and fixed coupon of most bonds mitigate this risk significantly).

All in all, I think cutting the dividend for a couple of years and accelerating deleveraging is a good move. If the stock eventually falls, BAT could step up its buyback plan and reward shareholders more efficiently. Regardless, for now, the stock is a hold and definitely a buy below $35, which is about 13% down from the current price at the time of writing.

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