Tobacco is a sector that the market loves to hate. There is a good reason for this relationship. Ever since the link between smoking and cancer was made public several decades ago, the industry has been under siege. Regulators and politicians have consistently placed new restrictions on the sector, hiked taxes and encouraged consumers to switch away from these cancer-causing products.
Many investors want to stay away from these companies, and I can understand why they don't want to be part of a business that sells an addictive product which will ultimately kill its user. Moreover, many see this as a dying industry with profits destined to decline over time.
However, despite all of the headwinds these companies face, they have been fantastic investments to own over the past couple of decades.
Cash cows
The numbers speak for themselves: tobacco companies are cash cows. They have navigated the increased regulations and raised prices while streamlining their operations. As a result, profit margins have remained relatively consistent and even increased. What's more, the total number of smokers worldwide has actually increased over the past couple of decades, although the percentage of people smoking has declined.
Tobacco companies have also started to branch out into so-called reduced-risk products. These heat-not-burn tobacco products and e-cigarettes are becoming big business, and they're winning favor with regulators. In the U.K., the health service recommends electronic cigarettes for patients who want to quit smoking.
British American Tobacco
Tobacco giant British American Tobacco (BTI, Financial)(LSE:BATS, Financial) recently reported a 40% increase in sales for reduced-risk products in its 2021 financial year. The division is still losing money (around 100 million British Pounds ($135 million) a year), but losses are falling, and management expects the unit to be profitable by 2025.
The rest of the business continues to exhibit the traits that the tobacco industry has been famous for over the past couple of decades. Cigarette sales are declining across the business, but steady price increases and efficiency savings more than offset these declines. The company is expecting revenue growth as much as 5% in 2022, even though total cigarette sales are expected to decline.
As Warren Buffett (Trades, Portfolio) once said, the tobacco industry is so successful because it can sell a product that costs a penny to make for a dollar. These fantastic economics are highly apparent in British American's cash flow figures. Last year, the company generated around £10 billion in operating cash flow and around £8.5 billion in free cash flow. Over the next five years, the company believes it can generate £40 billion in free cash flow before the payment of dividends.
Undervalued equity
Based on these numbers, the stock does look cheap compared to its current valuation. According to the GuruFocus discounted cash flow (DCF) calculator, using a 6% discount rate and a 3% per annum free cash flow growth rate indefinitely provides a $70 per share valuation.
Using a discount rate of 6% and assuming no growth, which is roughly in line with the company's own forecasts over the next five years, I get a $53 per share valuation.
I am using a discount rate of 6% to reflect the increased risk of investing in a tobacco company. Even if I ignore this calculation altogether and just use the company's cash return yield, the stock is currently offering a dividend yield of 6.5%.
The recently announced £2 billion share repurchase adds a couple of percentage points onto this total. I estimate the overall shareholder yield is around 8.5%, although this excludes the potential for debt reduction in the years ahead.
The stock is currently trading at a free cash flow ratio of 11%. This multiple looks incredibly attractive, although one also has to consider the risks of investing in the sector.
