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The Stock Picker's Guide to British American Tobacco

By Tony Reading - Apr 19, 2013 at 11:09AM

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A structured analysis of British American Tobacco.

LONDON -- Successful investors use a disciplined approach to picking stocks, and checklists can be a great way to make sure you've covered all the bases.

In this series I'm subjecting companies to scrutiny under five headings: prospects, performance, management, safety, and valuation. How does British American Tobacco (BATS 1.88%) (BTI 1.51%) measure up?

1. Prospects
Morality aside, tobacco's addictive nature and "cool" aesthetic guarantee a growing market. While volumes are declining in developed countries, increased emerging market consumption is driven by population growth and rising disposable incomes.

Threats are increasing taxation, sales of illicit tobacco and health-motivated regulation, with the enforcement of plain packaging in Australia (with the U.K. and EU considering similar measures) especially significant. Tobacco companies are slowly introducing alternative and safer products.

BATS is one of four companies that share three-quarters of global sales outside the state-run Chinese market. Its turnover is spread across the globe, with three-quarters of turnover in emerging markets and market leadership in 60 countries. That gives it pricing power and huge defensive characteristics.

2. Performance
BATS' strong competitive position is reflected in its results. Turnover declined marginally last year, though only because of currency effects. Operating profit has risen every year since at least 2005, and cost control means that's dropped through to the bottom line, with compound growth in EPS of 13% per annum over the past seven years.

3. Management
CEO Nicandro Durante has worked for BATS since 1981, becoming COO in 2008 and CEO in 2011. The FD and COO have also been with the company a long time.

An entrenched management team including a finance director who rose through the company ranks rather than coming from the profession, and a chairman with a slightly checkered past -- he was governor of the Bank of Ireland when it collapsed -- might raise questions over management oversight, but you can't fault their performance.

Executives have substantial shareholdings.

4. Safety
Net gearing is 115% and has been rising, though most debt is long term and interest cover is a reassuring 12 times.

Eleven billion pounds of goodwill wipes out BATS' net assets of 8 billion pounds, so it has negative tangible net assets. One billion pounds in pension deficit adds to the financial risk. But BATS' substantial cash flow finances dividends with a cover of 1.6 times, leaving sufficient surplus for share buybacks, and provides a strong safety net.

5. Valuation
I believe that a prospective price-to-earnings ratio of 15 and yield of 4.3% is a fair price for BATS' defensive characteristics.

If you don't have ethical objections, BATS is a reliable dividend payer and sound holding for any portfolio.

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Stocks Mentioned

British American Tobacco p.l.c. Stock Quote
British American Tobacco p.l.c.
$3,495.00 (1.88%) $64.50
British American Tobacco p.l.c. Stock Quote
British American Tobacco p.l.c.
$43.76 (1.51%) $0.65

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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