British American Tobacco (BAT) has been out of favour with investors since 2017 when its shares reached a record-high price of more than £56.
Over the next five years, BAT’s shares fell by as much as 50% as investors worried about the long-term future of the cigarette industry in an increasingly restrictive regulatory environment.
With BAT’s shares now close to £33 they have a dividend yield of 6.5% and that is very attractive to most dividend investors.
But British American Tobacco is facing large and obvious headwinds, so the real question is whether that attractive dividend is sustainable.
BAT has a long history of progressive dividend growth
If you’re looking for sustainable dividend growth in the future, it’s usually a good idea to look for sustainable dividend growth in the past. More specifically, I look for a long history of steady dividend growth, supported by growth across revenues, earnings and capital employed.
And as luck would have it, that’s pretty much what BAT has produced since 1998, when its financial services operations were demerged from its tobacco operations (like many other tobacco giants, BAT went on a somewhat bonkers diversification spree from the 1960s to the 1990s, but eventually refocused on tobacco in the late 1990s).
BAT’s growth has generally been steady and comfortably ahead of inflation, with revenues, earnings and dividends increasing by 5-6% per year over the last decade.
The outlier is capital employed, which increased dramatically in 2017. That was caused by BAT’s acquisition of Reynolds American, which increased BAT’s shareholder equity and debts (both key components of capital employed) by more than £50 billion and £30 billion respectively.
This huge acquisition turned BAT into the world’s largest tobacco company, but it’s also a problem because very large acquisitions are often like very large meals; they can give you serious digestion.
In this case, Reynolds American is a tobacco giant and is, therefore, a very similar business to British American Tobacco. That should have made the acquisition easier. Also, BAT already owned more than 40% of Reynolds American and they already had technology-sharing agreements in place, so even before the acquisition, the two companies had a close working relationship.
All of that should have made the integration of Reynolds American much easier and, as far as I can tell, the acquisition didn’t cause any major problems.
That’s good, but the acquisition did have a very negative impact on BAT’s headline profitability.
BAT’s headline profitability was good until it acquired Reynolds American
Profitability, measured by return on capital employed, is a key metric because it tells you a lot about:
- How competitive the company is (highly competitive companies tend to produce consistently higher returns on capital)
- How fast the company can grow by organically reinvesting some of its earnings (this tends to be lower risk than borrowing money to fund growth)
In BAT’s case, before 2017 it was consistently producing a net return on capital of around 20%, which is about double the average for UK large-cap stocks. On that basis, BAT looked like a very competitive and highly profitable business.
But after the Reynolds American acquisition in 2017, return on capital collapsed to little more than 5%, which fails to meet my return on capital rule of thumb:
- Rule of thumb: Only invest in companies that consistently produce net returns on capital above 10%
BAT now fails this test, but I don’t think its recent returns on capital accurately reflect the underlying economics of the business. Instead, I think they’ve been skewed downwards because BAT paid a high price to acquire Reynolds American.
Here’s how that works: Company A has £1m of capital employed and generates a £1m profit every year. That’s a fantastic 100% return on capital. Company B comes along and acquires Company A for £20m. The acquired business still produces £1m profit per year, which is a return of 5% on Company B’s £20m purchase, or a 5% return on capital.
This is basically what happened with BAT. It acquired Reynolds American and the combined business’s earnings went up, but because BAT paid a high price for the business, the headline return on capital collapsed.
However, the business that was producing 20% returns on capital before the acquisition is still there, and once you strip out the accounting distortions caused by the acquisition (mostly intangible assets like acquired goodwill and acquired brand value), the company’s returns on capital are still very good.
But headline return on capital wasn’t the only thing messed up by this acquisition.
BAT’s balance sheet is a mess which is gradually being cleaned up
Taking on £30 billion to buy another company was always going to blow a hole through BAT’s balance sheet. However, management thought that was a price worth paying because the acquisition would turn BAT into the world’s largest international tobacco company.
Being the global leader is nice, but the debt required to fund the acquisition left BAT’s balance sheet in a mess. Here’s my rule of thumb for debt:
- Rule of thumb: Only invest in a company if its debts are less than five times its ten-year average earnings
Over the last ten years, BAT earned an average of £5 billion per year, going from £3.8 billion in 2012 to £6.8 billion in 2021.
Immediately after the 2017 acquisition, its debts went from £20 billion to £50 billion. Its debts were already a little on the high side at £20 billion, but at £50 billion they were more than ten times its average profits.
Tobacco is a very steady business because millions of people can be relied upon to smoke cigarettes every day come rain or shine, but even so, I think a debt to average earnings ratio of ten is a serious risk.
Fortunately, the company has focused on reducing debt back towards something more sensible and, as things stand today, its debts are down to a little under £40 billion, giving BAT a debt to average earnings ratio of 8.
I still think that’s far too high, but management seems to be happy with that level of debt. In fact, the company recently announced that cash previously used to reduce debt will now be returned to shareholders through share buybacks.
I like buybacks as much as the next investor, but I’d rather see another year or two of additional debt reduction first.
BAT has a solid financial track record but its high debts are a potential problem
Overall, I think BAT’s track record is very solid if we ignore the price paid for the Reynolds American acquisition. If acquisitions were a core part of BAT’s business model then overpaying would be a serious problem, but it seems that this was a one-off event so the fact that management seems to have overpaid is less of an issue.
