British American Tobacco Stock: Analyzing Dividend Safety (NYSE:BTI)


View of the stack of cigarettes and tobacco.  The tobacco plant belongs to the Nicotiana genus and the Solanaceae (nightshade) family.

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British-American Tobacco (NYSE:BTI) has an ordinary dividend yield of 7.2%. While it’s not quite what it would be ideal for beating inflation, it’s coming close and that’s saying a lot in the current environment. The stock price is also up about 6.5% year-on-year (YoY). as of this writing, though the S&P 500 is down 12.5%, likely because it’s a financially healthy defensive stock in an uncertain time. However, high inflation and low growth are now beginning to take their toll on BTI. This article takes a look at its recent performance in the context of macroeconomics and more specifically what it means for the company’s dividends. It then takes into account the company’s market valuations to assess whether the stock price can continue to rise. He concludes that in the current challenging environment, it is best to hold the stock for now.

Can British American Tobacco thrive in a weak economy?

The three major challenges facing the macro economy at the moment are low growth, high inflation and rising interest rates, all of which are of course linked, but their impact on companies can be assessed differently. As in some of my previous articles, it analyzes the demand for the company’s products, its pricing power, and its ability to meet its commitments.

Demand is stable but expected to slow down

While BTI’s downside may be limited, it’s not immune to fluctuations in revenue. Its earnings, measured in its home currency GBP, have declined year-on-year in five of the last ten years. In 2022, however, trends so far are encouraging. According to the latest semi-annual report (H1 2022), sales showed a year-on-year increase of 5.7% after falling by 0.8% in H1 2021. In particular, the non-combustible products segment is gaining ground, which is positive even from a long-term perspective, while combustibles still account for 84% of sales.

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For 2022, however, the company recognizes that it is subject to the current macroeconomic environment. This is also reflected in an expected sales slowdown for full year 2022 to 2-4% sales at constant exchange rates compared to the growth expectation of over 5% that had been projected for the year before. While market exchange rate movements may impact overall sales growth, it is clear that real growth is expected to slow.

Result under pressure

It could take longer for a demand slowdown to show up in the numbers, but BTI’s earnings are clearly under pressure as costs are rising rapidly. Operating expenses increased by 26.5% year-on-year (H1 2021: 1.3%), indicating the impact of inflation on the business. This is reflected in the results as the operating result fell by 25% (H1 2021: -3.7%) while the net result even fell by 43% (H1 2021: -6%). This also translates into a sharp decline in margins, with the operating margin also down to 28.6% (H1 2021: 40.3%) and the net margin down over 12 percentage points from H1 2021 to 14.4%.

profits

Sources: British American Tobacco results, Financial Times, author estimates

This clearly means BTI is struggling to pass higher costs on to consumers. That’s a red flag, and given that earnings per share (EPS) growth will come in at “mid-single-digit currency-adjusted EPS growth,” which could well represent a further slowdown from the 5.7% adjusted diluted EPS increase constant exchange rates H1 2022. Margins still don’t look too bad in isolation. But if earnings continue to fall, there could be risks to dividends since the dividend coverage ratio is already below comfortable, which I’ll discuss in more detail later.

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Debt included

Next, let’s look at the debt picture given the rapid rate hikes. A decline in income has impacted the interest coverage ratio, which is now down to 4.9x (H1 2021: 6.5x) despite a modest decrease in actual interest expense. It hasn’t dropped to critical levels, but I would monitor this number based on recent earnings trends. Other debt indicators like the debt-to-equity ratio of 0.6x are looking good, as does the current ratio of 0.9x, suggesting that BTI is financially well-positioned should the company come under pressure.

What’s next for dividends?

Earnings pressure is the clear highlight of the three macro health checks for BTI. This ties directly to its dividends. The dividend coverage ratio based on the expected payout in the current fiscal year and consensus estimates for 2022 earnings per share is expected to be 1.4x. This is a bit of a downside for the company considering the ideal ratio should be at least 1.5x.

Some solace can be found in the fact that BTI has historically maintained a slightly lower ratio (see chart below). The only exception over the last 10 years was 2017, when the acquisition of Reynolds temporarily resulted in a huge surge in EPS. However, it’s also important to remember that maintaining, and even increasing, dividends even in times of shrinking profits is probably a red flag in itself.

Even now, if earnings come in as forecast, that ratio isn’t a problem. But given the unpredictability of the current macro environment and weak earnings, I wouldn’t bet on dividends. It’s worth noting that Seeking Alpha’s Dividend Scorecard ranks BTI’s dividend security as the lowest across various aspects of dividends such as growth, yield, and consistency, further indicating the risk to its dividends.

dividends

Sources: Seeking Alpha, author estimates

Though the company’s dividends have grown for most of the past decade, they’re not immune to fluctuations in exchange rates. Its dividends actually declined in USD terms in each of the four years through 2017, translating into a dividend cut, albeit unintentional. The numbers have gone up every year since, but I’d keep that in mind when buying the stock.

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The question of rating

Still, the price-to-earnings (P/E) ratio of 13.8x is lower than the S&P 500’s 19.1x and 21x for the consumer staples sector. This could hint at far more upside potential for the stock, but let’s not get too carried away. It’s not rated too badly compared to other tobacco companies (see table below). In fact, its forward P/E of 11.2x is the highest among its peers aside from Philip Morris International (PM). While defensive stocks could continue to post some gains if the economy continues to sag, the expected slowdown in both sales and earnings growth for BTI in 2022 suggests they will be subdued. I would also consider that the stock price hasn’t moved much in the last three years and there’s no particular reason it should be going up now. And if it cuts its dividends, it could actually fall.

market valuations

Source: Search for Alpha

Conclusion

BTI is a financially strong company with relatively limited downside compared to cyclical stocks. However, it’s still vulnerable to inflation, as evidenced by a double-digit increase in operating costs of late. This has weighed on earnings, which is a big concern given the company’s high dividend yield. An already lower-than-comfortable dividend coverage ratio during a period of reduced earnings growth implies a risk of passive income from the stock. If dividends are cut, the stock price could also take a hit, having remained flat for the past three years, making it a risky stock to buy. I would stop now.



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