British American Tobacco: The window to buy and lock in that 9.5% yield may be closing

Laqsla (New York Stock Exchange: PTI) is a leading manufacturer of tobacco and smokeless products. It owns well-known brands that are marketed globally, which include Dunhill, Lucky Strike, Rothmans, Kent, and Pall Mall. It has popular brands in the US which include Camel, Natural American Spirit, and Newport. They also sell vapor products such as Vuse and heated tobacco with Glo being one of the top brands. The stock price of this company appears to be undervalued and I think it has bottomed out. There are a number of reasons why I plan to accumulate this stock on pullbacks. In the last few days there has actually been a slight pullback which has prompted me to start buying more shares. Let’s take a look below at the pros and cons and why this seems like a good time to buy this extremely high-yielding product stock.

Chart

As shown below, this stock declined and bottomed in December 2023. The sharp decline that month was due to BTI announcing that it would take a $31.5 billion impairment charge for the brands it owned in the US. The stock has since managed to rally from that level and has been in a slightly uptrend. Its 50-day moving average is $29.93 and its 200-day moving average is $29.05.

Earnings estimates and balance sheets

Analysts expect this company to earn $4.71 in 2024, on revenues of $34.22 billion. For 2025, estimates are $4.98 per share, with revenue reaching $35.37 billion. 2026 results are expected to rise further with earnings estimates at $5.23 per share, with revenues totaling $36.44 billion. These estimates do not show a business that is declining, but rather one that has some growth that could easily support the earnings that the dividend covers very well. I believe this stock is undervalued as it is currently trading at about 6.5 times 2024 earnings estimates, and less than 6 times 2026 earnings estimates. I like to invest in companies that are expected to earn an amount equivalent to the current stock price in just about 6 years. . As the saying goes, “good things happen to undervalued assets.” I expected that between a very generous dividend and a potential rise in the stock price, this stock would provide strong total returns.

As for the balance sheet, BTI Bank has $50.89 billion in debt and about $6.71 billion in cash. In March 2024, Fitch Ratings upgraded BBB’s credit rating to ‘BBB+’. The upgrade was driven by a number of factors, including “improving leverage metrics,” and the expectation of further deleveraging driven by “improved profitability and strong free cash flow.” If these trends continue, I expect BTI to see further credit rating upgrades in the future which could boost investor confidence and reduce interest expenses.

Dividends and stock repurchases

BTI pays a quarterly dividend of about $0.74, so this provides a yield of just over 9.5%. This yield is very generous, yet it is well covered by earnings estimates, suggesting that it is safe.

Another way this company is shareholder friendly is through major stock buybacks. For example, in March 2024, BTI announced that it had sold part of its stake in an Indian tobacco company called ITC and that it would use those proceeds to buy shares worth $2 billion.

Industry forecasts and valuation

Cigarette smoking is declining by about 3% per year, which might seem like a problem, except for the fact that price increases of about 4% per year more than offset this decline. As shown below, BTI is on track for organic revenue growth of 3% to 5% for 2026 and beyond:

The barriers to entry for new competitors are very high due to regulations and other factors. Advertising of tobacco products is not allowed in many countries, this also makes it difficult for a new competitor to emerge, and also keeps BTI’s advertising budget low.

In terms of valuation compared to peers, BTI appears to be undervalued. For example, Altria (MO) is expected to earn just over $5 per share for 2024, and is trading at around $45. This means that the price-to-earnings ratio is about 9 times earnings. Analysts expect Philip Morris to earn about $6.30 per share and trade at about $100 per share. This means that the price-to-earnings ratio is around 15. This is more than double the price-to-earnings ratio that BTI currently holds. Part of this is due to the belief that Philip Morris is ahead in the smokeless market, but I still think this indicates that BTI is undervalued and could be rerated higher in the future.

Why the window to lock in this return may be closing

There are two main reasons why the opportunity to secure a return of around 9.5% may not last much longer. Obviously, the first reason is that BTI stock is trading at a discount to Altria and Philip Morris. Much of this discount was created when BTI took a huge discount of $31.5 billion, which I believe was an overreaction.

The other biggest reason in my view is the significant drop in interest rates over the next couple of years. A “point plan” forecast for the Fed funds rate from the Federal Open Market Committee suggests interest rates could rise from currently above 5% and fall to as low as about 2.25% by 2026.

This means we could see the return on money market funds decline by 50% between now and 2026. When interest rates on money market funds fall to this 2.5% level, it makes sense for investors to sell their money market funds and pay higher prices for them. . Dividend stocks. I think this would be a huge bullish catalyst for BTI stock. The market is currently willing to price BTI at a yield of around 9.5% when money market rates are just over 5%. However, I don’t see the market offering BTI a 9.5% return, if money market rates are around 2.25% in 2026. This means BTI shares could move much higher. If money market rates fall to about 2.25% in 2026, I could see BTI trading at $50 per share because the current dividend of about $3 per share would still provide a yield of about 6%. This could still be as much as three times the expected return of 2.25% for money market funds.

Other bullish catalysts

Marijuana could be legalized in the United States and other countries in the future. This could create a whole new market for tobacco companies like BTI and create growth in the industry. If this happens, I think the price to earnings multiple will expand significantly.

BTI still owns a significant stake in ITC, currently worth about $16.5 billion. This is a very important “hidden asset” that BTI has and selling more or all of this could give the company the opportunity to buy back more shares, reduce debt and even pursue new growth opportunities; For example, the marijuana market is likely to be in the future.

BTI and base 72

When investing in dividend stocks, it’s worth considering the “Rule of 72.” This enables you to calculate how long it will take to double your money. It works by dividing 72 by the yield. With British American Tobacco currently yielding around 9.5%, dividing 72 by 9.5 shows that it would take around 7.6 years to double your money with dividends. However, this stock may take less time than that due to the potential rise in the stock price. I expect this stock to rise when interest rates fall over the next couple of years.

Potential downside risks

Since this company is based in England, and because it derives most of its revenue from many other countries, it faces some currency risk, especially if the value of the British pound rises.

If governments imposed a complete ban on the sale of tobacco products, this would be a significant downside risk. I don’t see that happening because politicians know that many retirees rely on income stocks like BTI and that this industry provides significant tax revenues for the government. If smoking rates decline at a faster pace in the future, this would also make it difficult for this company to meet earnings estimates.

A global recession is another potential downside risk to consider. In a difficult economic environment, this may cause some consumers to cut back on their discretionary spending. However, it should be noted that the tobacco industry is recession-resistant compared to other businesses.

In summary

I see BTI shares as partly mispriced due to headlines attracting delisting earlier this year, and undervalued. This stock is showing signs of hitting bottom, and the yield is very generous now. It would be more beneficial for investors to lock in that yield now before the federal funds rate and money market rates fall to about 2.25% between now and 2026. I also see BTI’s multibillion-dollar stake in the ITC as something that should More investors have to do to focus on it, especially since the company has begun selling this stake, which could fund more stock buybacks.

There could be a very profitable new growth opportunity for tobacco companies, if marijuana is legalized nationally in the United States. It appears to be heading towards legalization and this is a major potential bullish catalyst for the future.

Dividends are too attractive to pass up now, and appear too safe as the yield is well below earnings estimates for this year and beyond. I see this stock trading back towards $50 when prices decline as the Fed expects between now and 2026.