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This Tobacco Stock Looks Attractive Enough

July 23, 2014 | About:

ovenerio

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In this article let's take a look at an option for investing in the tobacco sector with British American Tobacco plc (BTI), which sells tobacco products in 180 countries. The company holds leadership positions in around 50 of them. Brands like Dunhill, Kent, Pall Mall, and Lucky Strike account for one third of group sales because they are well known and have been gaining share over the past several years.

Competitive Advantages

Two remarkable points for the company are its strong brand loyalty and cost advantages. The firm focuses on product innovation and cost reduction, while we know both things might be difficult to achieve at the same time.

The tobacco sub-industry is extremely competitive but consumer´s loyalty is a very important characteristic. Although in times of recessions some consumers switch to cheaper brands, the company focuses on innovation. The launching of line extensions at a price premium to the heritage brand, increase complexity and costs, is a less risky strategy than competing on price.

Top Global Cigarette and Cigar Manufacturers by Revenue



Company



Symbol



Price



Market Cap



P/E



British American Tobacco plc



BTI



120.36



113.56B



17.50



Imperial Tobacco Group plc



ITYBY



89.83



43.18B



37.31



Reynolds American Inc.



RAI



58.16



31.18B



20.09



Lorillard, Inc.



LO



61.05



22.13B



20.16

British American Tobacco generates operating margins of more than 30% that are a bit below the industry. Its three main competitors: Philip Morris International, Imperial Tobacco (excluding the logistics business), and Japan Tobacco (in aggregate), each one generates margins of 40%. This means that there is space for a margin expansion.

Cash to Investors

A company characteristic is that demonstrate its commitment to return cash to investor in the form of dividends. The current dividend yield is about 4%, which is considered very good to protect the purchasing power. The company will continue to pay out two thirds of its adjusted net income as dividends.

Return on Equity

Let´s compare the best measure of performance for a firm's management: the return on equity. The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.



Ticker



Company



ROE (%)



BTI



British American Tobacco



56.29



RAI



Reynolds American Inc



33.25



LO



Lorillard



N/A







Industry Mean



17.08

The company has a current ratio of 56.29% which is higher than the one exhibit by Reynolds American Inc. (RAI) and also the industry mean. In general, analysts consider ROE ratios in the 15-20% range as representing attractive levels for investment. It is very important to understand this metric before investing and it is important to look at the trend in ROE over time.

1406119683039.png

Relative Valuation

In terms of valuation, the stock sells at a trailing P/E of 17.4x, trading at a discount compared to an average of 19.5x for the industry. To use another metric, its price-to-book ratio of 9.7x indicates a discount versus the industry average of 10x while the price-to-sales ratio of 4.38x is above the industry average of 3.85x. The first two metrics indicate that the stock is relatively undervalued and seems to be an attractive investment relative to its peers, because at that ratios it seems cheaper compared to the industry average.

As we can see in the next chart, the stock price has an interesting upward trend in the five-year period. The EPS are included because it often leads the stock price movement.

1406083831406.png

Final Comment

This industry faces strict anti-smoking regulation, taxation and high barriers to entry, make it attractive for well-known brands. Further, the tobacco portfolio and e-cigarettes gives the firm economies of scope and scale that make it difficult for new entrants to compete.

Despite the industry has strong competition, the business is relatively stable; government intervention is an omnipresent threat and litigation risk is lower for the European players, so I would recommend fundamental investors to consider this attractive option for their long-term portfolios.

Hedge fund gurus like Sarah Ketteter, Tom Russo (Trades, Portfolio) and John Rogers (Trades, Portfolio) added this stock to their portfolios, and I would advise fundamental investors should consider adding this stock to their long-term portfolios.

Disclosure: Omar Venerio holds no position in any stocks mentioned

About the author:

ovenerio
We provide independent fundamental research and hedge fund and insider trading focused investigation.

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