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Betting on Tobacco
Posted by: Fede Zaldua (IP Logged)
Date: January 22, 2014 09:28AM

Most tobacco companies are facing a shrinking demand in the developed world while their markets are still expanding in the developing countries of Asia and Latin America. Besides, tobacco companies also face increasingly tougher governmental policies and extremely high (and growing) tax rates. That said, tobacco companies are strong cash flow generators that pay high cash dividend yields and sell for a significantly lower price than most other consumer goods companies. Here I will take a look at my favorite large international tobacco company. Its not the one company with the higher cash dividend yield nor the most profitable one but its the one company with the largest exposure to emerging markets.

One Bet on Emerging Markets

British American Tobacco (BTI) is one of the best stock in the staples space thanks to its earnings visibility given by the company's on going cost saving measures that support the continued margin expansion which, in turn, provides single digit sustainable EPS growth.

On top of the aforementioned continued margin expansion, British American Tobacco is gaining market share thanks to its constant investments in brand equity, above all in high growth emerging markets such as Brazil (15% of sales). As a matter of fact, the company has been able to achieve one of the highest exposures to emerging markets among the consumer staples space - 60% of sales – which is always a plus for consumer goods companies. According to the best analysts on the street, British American Tobacco should hit the 40% EBIT margin target by 2016 and, even then, there would still be large room for margin improvement since Philip Morris International's (PM) margins are significantly higher at 43%.


With market trends now ameliorating in Western Europe and price-volume mix expansion in the emerging world, the owner of brands such as Lucky Strike looks like a fairly price bet on the subsistence of the tobacco industry. Even when its EPS growth targets are far below those present at Philip Morris International - held by Joel Geenblatt and Mario Gabelli (Trades, Portfolio) - I believe British American Tobacco is one stock to take a look at.


On Valuation


Even when Philip Morris International is the best company within the tobacco sub sector, British American is poised to match Philip Morris's margins and the company sells at significantly lower multiples. While Philip Morris International sells for 2014 15.4 times earnings and 11.8 times EV/EBITDA, British American Tobacco trades at 2014 14.5 times earnings and 10.4 times EV/EBITDA. Over time - two to three years - I think the now existent gap between the valuation of the two companies should at least partially disappear.


On the other hand, the entire sub sector is now trading at a discount to its historical average. Nowadays, tobacco trades at a 30% discount to overall consumer staples, which is one standard deviation below the 10 year average of 20%. High and sustainable dividend yields are also a great incentive to own tobacco companies within your portfolio: British American Tobacco pays a 4.28% cash dividend yield while Philip Morris International pays a 4.5% cash dividend yield.

Stocks Discussed: BTI, PM,
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