HomeBusinessSmart capital allocation, dividend yield of 9.7%

Smart capital allocation, dividend yield of 9.7%

British-American tobacco (NYSE:BTI) (LSE: BATTEN) shares continue to trade at low levels. However, recent smart capital allocation practices, combined with stocks currently pegged at a whopping 9.7% yield, should support the bullish trend. Admittedly, the negative sentiment on Wall Street is not unfounded as cigarette sales volumes remain under pressure worldwide. Nevertheless, advances in non-combustible fuels and a clear path to creating shareholder value provide a promising example. So I remain bullish on BTI stock.

Sales of flammable substances remain under great pressure

Let’s start by addressing the most glaring bearish factor in BTI’s investment scenario: the heavy push on combustible fuels, sales volumes of which have been declining at an alarming rate lately. To be sure, there are other factors pushing share prices down, including high interest rates, regulatory risks, the general bearish sentiment affecting the UK stock market, and the broad distaste many investors have for tobacco stocks. Yet, the challenges related to combustibles appear to be the most prominent catalyst.

In the company’s H1 2024 comments, management addressed this issue and noted that combustible fuels industry volumes are down approximately 9% this year and down approximately 11%, excluding the discounted brand market, where BTI does not is present. We’ve seen similar declines recently at some of BTI’s peers, such as Altria (NYSE:MO) and Philip Morris (NYSE: PM) in their respective cigarette-based divisions, confirming the rather difficult market conditions in the product category.

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Nevertheless, BTI was once again able to more than offset these product category-wide declines through pricing. Combustible fuels generated £10.65 billion for BTI during the first six months of the fiscal year, up from last year’s £10.50 billion. Other successes in this area include the strong performance of the company’s Newport brand, which, together with market share gains from the Natural American Spirit brand, increased its volume share in the Premium segment by 40 basis points compared to last year.

Non-combustibles continue to make progress

While BTI’s combustibles division finds ways to survive and even thrive in the challenging industrial environment, non-combustible products showed signs of improvement across the board.

  • In Vapour, Vuse managed to maintain global leadership with a 41.1% value share, despite a dip in the US due to illegal vaping.

  • In Heated Products, Glo’s volume share is starting to stabilize, down just 20 basis points year-to-date, compared to a decline of 110 points in 2023.

  • In Modern Oral, Velo excelled, increasing BTI’s total oral volume share by 80 basis points to 10.3%. BTI held 65% of the Modern Oral category in AME (Americas ex-US and Europe), leveraging its position in established markets such as Sweden and newer markets such as the UK and Poland.

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This enabled the company to grow the division’s turnover to £2.16 billion, up from £2.10 billion last year.

Smart capital allocation, high returns seal the deal

Business aside, BTI’s management appears to have made some smart capital allocation decisions in an effort to address current investor concerns and improve shareholder value. Together with the high return of the stock, I am convinced that BTI’s investment situation remains quite attractive.

Notably, in March, BTI successfully completed the sale of a 3.5% stake in its ITC share (ITC is India’s largest listed tobacco player), enabling the start of a sustained share buyback, including plans for £ 700 million in 2024 and £900 million in 2025. BTI is also using its own free cash flow to reduce debt. Management expects the company to achieve its scaled-down leverage target of 2.0-2.5x adjusted net debt/adjusted EBITDA by the end of 2024.

In the meantime, the shares remain tied to a solid dividend yield of 9.7%. The dividend was increased again this year, with the current annualized rate standing at £2.3552 (or about $2.79). It remains adequately covered by adjusted earnings per share (EPS), which is expected to reach £3.62 this year.

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Such a hefty, well-covered dividend yield should provide a notable margin of safety against further short-term price losses. Furthermore, BTI buybacks at current levels should be quite beneficial as the savings on future dividends will be huge for shares bought back at current levels.

Are British American Tobacco shares a buy according to analysts?

As for Wall Street’s view on the stock, BTI stock has a consensus rating of Moderate Buy, based on five Buys and three Hold ratings assigned in the last three months (on the UK listing, where the stock is better is covered). At 2,966.67p (approximately $38.09 at the current exchange rate), British American Tobacco’s average price target suggests 24.1% upside potential.

The takeaway

While British American Tobacco is not immune to the challenges facing the combustible fuels sector in general, its brands continue to deliver solid results. In addition, the Non-Combustibles division shows improvements across the board.

To top it all off, management appears to be decisive in improving the balance sheet and rewarding patient shareholders who have stayed with BTI, showing a welcome mix of debt repayment and capital return. Considering all factors, BTI’s bullish situation seems promising, which is why I remain a shareholder in the stock.

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