There’s a price for almost every (profitable) businesses where the valuation is so low that almost nothing needs to go right for the stock to generate attractive returns.
Thanks Dan. Nice write up. Do you have any idea if illicit vapes have loyalty like cigarettes have? My understanding is that at least some of the time, the vape "juice" can be used with a variety of consumption devices.
I think the jury is still out on loyalty for new categories, it's something we've talked about quite a bit but don't have any definitive conclusions yet. I do think legacy tobacco businesses distribution know-how and scale will likely confer significant competitive advantages in new categories.
My problem is with the 20% FCF yield, what happens when revenue and FCF decline? If FCF doesn't decline in the long term due to the new categories and/or price offsetting volume drop, it's a nobrainer.
Otherweise you have to reduce debt to maintain the same leverage (debt/FCF). But when you constantly have to reduce debt, FCF available for distribution declines even further, with a double pace depending on the leverage. So if I'm correct, you have to deduct not only the rate of decline from the FCF yield, but more, to get to the shareholder return?
Winter - yes, if your view is that free cash flow per share will decline in perpetuity or significantly in the near future, there's almost no FCF yield that would interest me (even though the price is so low that anything better than a precipitous decline may still produce acceptable returns). This is why we don't like unpredictable businesses. I don't view declining revenue and FCF to a significant degree as probable over the long-term, but that's up to each investor to determine.
I'm not sure that's how I would view the impact of debt reduction on forward returns. Earnings would have to deteriorate substantially to put the dividend at risk due to outsized debt service (the company could also just monetize more of the equity in ITC as well). Also, delevering creates a dollar-for-dollar increase in equity value, so shareholders should benefit from the full FCF yield. It doesn't matter if the FCF is used to pay down debt or to pay dividends, either way equity holders benefit the same (either by an increase piece of the enterprise value accruing to equity holders or by way of direct cash distributions).
In short, either the market is right and earnings will collapse and the current price will prove justifiable or earnings will prove stable and shareholders will benefit accordingly in the years ahead. Time will tell!
I don't regard it as an unpredicable business anyway, rather the opposite, at least not the traditional cigarette business. Only the new categories are difficult to predict, because the market share is not yet set. That's what I like about Imperial Brands, you just have to estimate the rate of decline or growth.
A perpetual decline is not the base case, but a conservative or bear case. If it produces acceptable returns even in this case, the shares are interesting. But it's the question, if it does. For IMB, my bear case assumption is -5% decline in revenue and FCF (maybe only minus 3-4%) and for BAT, it would be -3% or maybe only -1%.
It doesn't matter, if the FCF is returned to shareholder via dividends or buybacks. But regarding debt reduction as a creation of value: Don't we have to use the unlevered FCF/EV metric in this regard? Due to the significant amount of debt, this metric is less favourable than (levered) FCF/MCap.
According to my notes from November, it's @24 GBP as follows:
For the 15,1%, my model was that 2% of FCF is needed to reduce the debt accordingly in case of a decline of -3% p.a., so we end up with 10%. That's still ok!
With the 10,7%, you still would have to deduct the rate of decline of -3%.
I read many write-ups on BAT, some even with models and also the assumption of a future decline, but none addressed the topic of debt reduction.
So, 10% in case of -3% decline, and 15% in case of zero growth. Their goal is 2-4% growth until 2026, then 4-6% for the ten years thereafter.
Feel free to shoot me an email if you're interested in discussing in detail, but delevering is a direct benefit to equity holders as each dollar of debt reduction builds equity value, so equity holders returns should approximate FCF yield + growth. This is effectively in part how leveraged buyouts create equity value, but the same dynamic holds in public equity markets.
I think this is not fully correct. I accept that we should look at FCFE/MCap instead of FCFF/EV, ok.
But the cash outflow that is needed to delever does not benefit shareholders. I don't know how to put it better: Except if we already accounted for it, which we did not. We are considering a DCF, thus FCF to equity under the condition of a necessary reduction in debt over an infinite period.
If you remember your CFA: ;)
FCF to equity := operating CF - CapEx + net debt issuance
Good write-up, one question though - where do you get the market cap of $51b from? Market cap appears to be ~$68b. Wondering if you may have accidentally used the GBP market cap (but used the USD FCF to conclude a P/FCF of 5)?
Hey Matt - thanks for reading. The market cap in USD is $68B, and FCF in USD is ~$13B. In GBP market cap is ~$53B and FCF is ~$10.2B. In either currency the stock is around 5x FCF.
Matt - good point, my free cash flow numbers are after interest as well. I'll leave some of the fun in valuing ITC stake and underlying core free cash flow to you (I will say don't forget to also subtract earnings that are attributable to ITC), but the beauty of a stock trading for a single digit multiple is that you do not need to carry out the calculations to several decimal points. As Buffett says, you don't need a scale to know if a 400 lb. man is fat!
Don't worry, ITC earnings were subtracted in the valuation given.
I appreciate the sentiment that you don't need to know the multiple to several decimal points - but still, the difference between 4 and 5.2 is pretty substantial, and for a business whose cash flows are likely to decline somewhat in the future, it'd be daft to treat that as a rounding error in my opinion. 4x would be an absolute no brainer; 5.2 warrants a little more investigation and thought.
A very sensible perspective, Dan. I appreciate the shoutout toward Invariant. If you'd ever like to talk specifics of BAT or other industry names, never hesitate to reach out.
Excellent writing, thanks for the insight.
Thanks Dan. Nice write up. Do you have any idea if illicit vapes have loyalty like cigarettes have? My understanding is that at least some of the time, the vape "juice" can be used with a variety of consumption devices.
I think the jury is still out on loyalty for new categories, it's something we've talked about quite a bit but don't have any definitive conclusions yet. I do think legacy tobacco businesses distribution know-how and scale will likely confer significant competitive advantages in new categories.
Thank you for highlighting my work on British American Tobacco.
No problem, thanks for the solid coverage on BTI and others.
when you say leverage ratio is 2.5x, do you mean net debt divided by EBITDA?
My problem is with the 20% FCF yield, what happens when revenue and FCF decline? If FCF doesn't decline in the long term due to the new categories and/or price offsetting volume drop, it's a nobrainer.
Otherweise you have to reduce debt to maintain the same leverage (debt/FCF). But when you constantly have to reduce debt, FCF available for distribution declines even further, with a double pace depending on the leverage. So if I'm correct, you have to deduct not only the rate of decline from the FCF yield, but more, to get to the shareholder return?
Winter - yes, if your view is that free cash flow per share will decline in perpetuity or significantly in the near future, there's almost no FCF yield that would interest me (even though the price is so low that anything better than a precipitous decline may still produce acceptable returns). This is why we don't like unpredictable businesses. I don't view declining revenue and FCF to a significant degree as probable over the long-term, but that's up to each investor to determine.
I'm not sure that's how I would view the impact of debt reduction on forward returns. Earnings would have to deteriorate substantially to put the dividend at risk due to outsized debt service (the company could also just monetize more of the equity in ITC as well). Also, delevering creates a dollar-for-dollar increase in equity value, so shareholders should benefit from the full FCF yield. It doesn't matter if the FCF is used to pay down debt or to pay dividends, either way equity holders benefit the same (either by an increase piece of the enterprise value accruing to equity holders or by way of direct cash distributions).
In short, either the market is right and earnings will collapse and the current price will prove justifiable or earnings will prove stable and shareholders will benefit accordingly in the years ahead. Time will tell!
I don't regard it as an unpredicable business anyway, rather the opposite, at least not the traditional cigarette business. Only the new categories are difficult to predict, because the market share is not yet set. That's what I like about Imperial Brands, you just have to estimate the rate of decline or growth.
A perpetual decline is not the base case, but a conservative or bear case. If it produces acceptable returns even in this case, the shares are interesting. But it's the question, if it does. For IMB, my bear case assumption is -5% decline in revenue and FCF (maybe only minus 3-4%) and for BAT, it would be -3% or maybe only -1%.
It doesn't matter, if the FCF is returned to shareholder via dividends or buybacks. But regarding debt reduction as a creation of value: Don't we have to use the unlevered FCF/EV metric in this regard? Due to the significant amount of debt, this metric is less favourable than (levered) FCF/MCap.
According to my notes from November, it's @24 GBP as follows:
FCF/MCap = 8.098/53.500 = 15,1%.
Whereas FCF/EV = (10.394 - 705)/(53.500 + 37.259) = 10,7%
For the 15,1%, my model was that 2% of FCF is needed to reduce the debt accordingly in case of a decline of -3% p.a., so we end up with 10%. That's still ok!
With the 10,7%, you still would have to deduct the rate of decline of -3%.
I read many write-ups on BAT, some even with models and also the assumption of a future decline, but none addressed the topic of debt reduction.
So, 10% in case of -3% decline, and 15% in case of zero growth. Their goal is 2-4% growth until 2026, then 4-6% for the ten years thereafter.
Feel free to shoot me an email if you're interested in discussing in detail, but delevering is a direct benefit to equity holders as each dollar of debt reduction builds equity value, so equity holders returns should approximate FCF yield + growth. This is effectively in part how leveraged buyouts create equity value, but the same dynamic holds in public equity markets.
I think this is not fully correct. I accept that we should look at FCFE/MCap instead of FCFF/EV, ok.
But the cash outflow that is needed to delever does not benefit shareholders. I don't know how to put it better: Except if we already accounted for it, which we did not. We are considering a DCF, thus FCF to equity under the condition of a necessary reduction in debt over an infinite period.
If you remember your CFA: ;)
FCF to equity := operating CF - CapEx + net debt issuance
https://corporatefinanceinstitute.com/resources/valuation/free-cash-flow-to-equity-fcfe/
The latter part is not included in my 15% from March.
In this case, net debt issuance is negative, and necessarily so over the long term, unlike in most other modeled scenarios.
Good write-up, one question though - where do you get the market cap of $51b from? Market cap appears to be ~$68b. Wondering if you may have accidentally used the GBP market cap (but used the USD FCF to conclude a P/FCF of 5)?
Hey Matt - thanks for reading. The market cap in USD is $68B, and FCF in USD is ~$13B. In GBP market cap is ~$53B and FCF is ~$10.2B. In either currency the stock is around 5x FCF.
You're right on the numbers. FYI as a british person it is very confusing to see someone use a dollar sign for GBP. Using £ will avoid such confusion.
At 5x FCF this is very tempting. But let me know your thoughts on this slightly less bullish article: https://www.simplysafedividends.com/world-of-dividends/posts/1468-regulations-weigh-on-british-american-tobacco-s-long-term-prospects
Thanks, Matt - good suggestions!
Oh, one more thing I've just noticed while looking at BAT - their cash flow number is before interest. Here is my calculation of 2023 owner earnings:
-15751 (profit from operations) + 28614 (impairment, D&A) – 2500 (tax) – 1900 (interest) – 500 (capex) = £7963m.
On a current market cap of £53.65b, that's a PE of 6.7. However, that calculation does not include the results of ITC. Their share is worth £12.4b.
(53.65-12.4)/7.963 = 5.18. In the post, you suggested the business not including the ITC stake was at a multiple of 4. Where did that come from?
Matt - good point, my free cash flow numbers are after interest as well. I'll leave some of the fun in valuing ITC stake and underlying core free cash flow to you (I will say don't forget to also subtract earnings that are attributable to ITC), but the beauty of a stock trading for a single digit multiple is that you do not need to carry out the calculations to several decimal points. As Buffett says, you don't need a scale to know if a 400 lb. man is fat!
Don't worry, ITC earnings were subtracted in the valuation given.
I appreciate the sentiment that you don't need to know the multiple to several decimal points - but still, the difference between 4 and 5.2 is pretty substantial, and for a business whose cash flows are likely to decline somewhat in the future, it'd be daft to treat that as a rounding error in my opinion. 4x would be an absolute no brainer; 5.2 warrants a little more investigation and thought.
A very sensible perspective, Dan. I appreciate the shoutout toward Invariant. If you'd ever like to talk specifics of BAT or other industry names, never hesitate to reach out.
Thanks, Devin - appreciate all of your work on the industry.