Photo: Richard Drew/AP
Photo: Richard Drew/AP

Consider BAT an opportunity as a rand hedge annuity

By Opinion Time of article published May 3, 2021

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By Ryk de Klerk

THE PERFORMANCE of British American Tobacco (BATS) over the past 12 months probably has many investors up in arms, specifically those invested in unit trusts and other savings products with significant holdings in BATS, the world’s largest tobacco company based on sales in 2019.

From the outside, it seems like a horror story. The Nasdaq-listed BATS is down nearly 5 percent in dollar terms from a year ago, the stock is down by about 13 percent in British pounds on the London Stock Exchange and some 24 percent in rands on the JSE.

Over three years, BATS’s share price underperformed the FTSE/JSE All Share Index by 32 percent and the JSE industrial board, as measured by the FTSE/ JSE Capped Industrial 25 Index, by more than 27 percent.

Sure, due to massive out-performance, the weights of tech stocks in the broad market indices have increased significantly and are likely to increase further in future.

It is essential to compare the performance and valuation of BATS to the global consumer stable universe and, more importantly, to Philip Morris, BATS’s main competitor in the tobacco products market.

Although volatile, from December 2018 to June last year, BATS and Philip Morris, both in dollar terms, tended to follow the trend and price performance of the global consumer stable universe, as measured by the iShares Global Consumer Stable ETF in dollars.

Since June, however, major trend changes are evident. BATS began to under-perform both Philip Morris and the iShares Global Consumer Stable ETF.

Furthermore, over the past three months, Philip Morris outperformed the ETF and BATS by more than 11 percent and 15 percent, respectively.

Consumer staple shares such as BATS tend to outperform consumer discretionary shares and broad market indices when black swan events occur.

Investors head for the hills, implementing risk-off strategies, resulting in major sell-offs in risk-on assets and volatility across markets shoots through the roof.

Consumer staple stocks, however, as in the case of gold, severely underperform broad equity markets when volatility subsides.

As things stand, it seems the severe under-performance of BATS compared to the broad JSE indices since the markets returned from anxiety (high volatility) in March last year to the current exuberance (low volatility) is overdone.

BATS’s price-to-earnings of just below 10 times earnings is undemanding. The average PE gap between Philip Morris and BATS (based on as-reported earnings) since December 2018 is 7 times and is currently 8.6 times using Friday’s closing prices in dollars.

What it means is that BATS could currently be trading at a discount of about 20 percent to Philip Morris if the average PE gap of 7 times earnings holds true.

The average dividend yield gap between BATS and Philip Morris was about 0.7 percent from December 2018 to March last year. Since July, the average yield gap widened to 1.7 percent and is currently 2.4 percent.

What it boils down to is, all other things being equal, if the dividend yield gap narrows to the recent average of 1.7 percent, BATS could outperform Philip Morris by about 28 percent.

My calculations indicate that BATS managed to improve its return on capital employed to 8.5 percent from 7.5 percent in the 2018 financial year despite many challenges facing the tobacco industry, specifically the Covid-19 pandemic.

In the past, tobacco companies were viewed by many as health hazard investments, and demand for combustible tobacco products such as cigarettes was declining.

The outlook for BATS and Philip Morris was aptly summarised in BATS’s chairperson’s statement at the 2021 annual general meeting last week, where he said: “BATS is transforming into a high-growth, multi-category consumer goods business, with a purpose to reduce its health impact, driven by meeting evolving consumer needs.”

The company’s reduced-risk and new-category products are growing by 15 percent a year, thereby slowly but surely taking up the slack in demand for combustibles.

This financial year’s earnings per share are expected to come in at mid-single figure growth in pound sterling terms, and the same can be expected in dividend growth.

Yes, it’s not much to get excited about. BATS faces headwinds, though.

The US Food and Drug Administration has moved to ban all menthol cigarettes, and apparently BATS would be hurt most. BATSs chairperson’s response last week was that “such regulation would be highly complex and could take many years to implement”.

The attraction of BATS lies in the fact that the share’s massive under-performance over the past year led to the share currently trading at a mere 5 percent premium to net asset value (shareholders’ interest) per share of 2 551 pence. That compares to a premium of 24 percent at the end of the 2019 financial year.

The share is currently at a dividend yield of about 8 percent, and although I expect dividend growth of 5 percent a year over the next few years, BATS to me is effectively an annuity in pound sterling.

The principal or capital outlay in buying the shares is not guaranteed, though.

In my opinion, British American Tobacco plc shows there is still value to be found among large-cap stocks in a frothy market with lofty valuations. That is why BATS is now a core holding in my investment portfolio.

Graph: Supplied
Graph: Supplied
Graph: Supplied

Ryk de Klerk is analyst-at-large. Contact [email protected] He is not a registered financial adviser and his views expressed above are his own. He has a direct interest in BATS. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.

*The views expressed here are not necessarily those of IOL or of title sites


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