Article Thesis

British American Tobacco p.l.c. (NYSE:BTI) (OTCPK:BTAFF), which had been inexpensive for a while, saw its shares slump by close to 10% on Wednesday when the company stated that it would write down the value of some of its intangibles. I believe that this non-cash item is not a drastic issue and that the fearful market reaction provides a nice investment opportunity in this very inexpensive stock that is offering a juicy yield of 10% at current prices.

What Happened?

Many traditional income stocks have been unloved in recent months and saw their prices decline, due to a combination of investors moving towards fixed-income investments such as CDs that got more attractive thanks to rising rates, while investments being shifted towards the “Magnificent 7” and cryptocurrencies played a role as well. British American Tobacco had thus seen its share price decline even before Wednesday’s news, but when those were announced, British American Tobacco declined by another 9%.

Intangible asset writedown

So what caused the company’s steep share price decline? Did the company cut its dividend? It didn’t. Did it lose a big lawsuit that will cost the company billions of cash? It didn’t. Instead, the company announced that it would write down some of the intangible assets held on its balance sheet. As the name suggests, these are intangible – these aren’t inventories, production plants, and so on, but rather brand value and other items, oftentimes “created” on a company’s balance sheet via a takeover: Let’s say company A buys company B for $10 billion, and that the value of the tangible assets (inventory, real estate, machinery, and so on) that company B owns is $5 billion. In that case, a $5 billion intangible asset called “goodwill” will be created on the acquirer’s balance sheet.

British American Tobacco has made many acquisitions in the past, thus it is not a surprise that there was a large sum of intangible assets on BTI’s balance sheet: Seeking Alpha reports that goodwill and other intangible assets amounted to a hefty $155 billion at the end of the most recent quarter. However, it is important to know that this is purely an accounting item, created primarily via M&A. I don’t believe that many investors – or the company’s management – thought that they could sell some brand names etc. for $155 billion. Still, accounting guidelines force BTI (and other companies) to write down intangible assets over time, and sometimes there will be major one-time adjustments. Kraft Heinz (KHC) has had major intangible write-downs in recent years, for example, and just like with BTI, Kraft Heinz had created these intangible assets via major M&A deals in the past.

When assets are written down, no cash is leaving the company. So while the intangible assets line on British American Tobacco’s balance sheet will be adjusted downwards by $31.5 billion, the company’s cash position is not impacted at all. The company will own the exact same amount of cash it owned before the write-down, and the company’s cash flows (both operating cash flows and free cash flows) are also not impacted by this intangible asset write-down. If the company was forced to pay out $31.5 billion, that would have been a drastic issue, and it would be likely that the dividend would be cut in such a scenario. But with no cash leaving the company, the dividend is not at risk – or, more precisely, the dividend is as risky as it was before the intangible asset write-down (I believe that the dividend cut risk is low, although it is never zero).

So while I understand that many investors got restless reading about a $31.5 billion hit to British American Tobacco’s balance sheet, the issue seems far from drastic once we take a closer look. Intangible asset write-downs are normal, cause no cash outflow, and do not impact future profits, cash flows, or dividends. The book value of BTI will decline, but I do not believe that BTI is a stock that should be valued based on its book value – and I have so far not seen anyone using this metric when it comes to BTI. Instead, BTI is usually valued based on the profits and cash flows it generates, and/or the dividends it pays. And since these are not impacted by this news, it is surprising to see BTI decline by almost 10%, especially since the stock was already rather cheap before this price slump. Of course, when fearful investors sell, this can be an opportunity for those who are willing to benefit from the reduced share price – being greedy could pay off here, I believe.

Some other news

There were some other news in the very recent past as well. First, British American Tobacco also announced that it sees its revenue growth at the lower end of the guidance at constant currency rates. Revenues will thus grow by around 3% during the current year instead of 4%, which was the previous guidance midpoint. While that’s not great news, it is far from a disaster – a 1% revenue change does not warrant a steep sell-off, and the important thing is that BTI will still grow this year.

On top of that, there was some good news: A possible menthol cigarette ban in the US will take longer than previously thought, which means British American Tobacco and other tobacco companies can sell their menthol cigarettes for a longer time, compared to what was previously assumed. All else equal, this should result in higher lifetime profits and cash flows for the company.

British American Tobacco: Inexpensive High-Yielder

The tobacco industry isn’t what comes to mind when we think about growth industries, but a part of the tobacco industry continues to expand at a nice clip: Reduced-risk products, or tobacco/nicotine products that do not work via burning tobacco. This includes vapes, heat-not-burn devices, pouches, and so on. Philip Morris (PM) is very successful in this space thanks to its iQOS product, but British American Tobacco is a major player as well. BTI’s reduced-risk products portfolio shows appealing business growth, and the company’s management believes that this will hold true in the future, too. While these businesses were not profitable when they were rolled out, profitability improved as these businesses scaled up, and in a Wednesday note, Jefferies analyst Owen Bennett reminded us that both BTI’s pouch business and its vape business have become profitable already.

British American Tobacco believes that growth in its reduced-risk products portfolio will more than offset declines in the traditional cigarette portfolio, which is why the company guides for revenue growth in the 4% range in the long run, with profits seen growing by around 5% per year in the long run. There is no guarantee that these targets will be hit, but even if the company’s profits were to grow at a low single digits pace only, that would still be far from a disaster. In fact, even zero growth in the long run would arguably make British American Tobacco a very solid investment at current prices. After all, the company trades for just 6.4x this year’s net profits, which makes for an earnings yield of around 16%. When the going-in yield is this high, not a lot of growth is needed for nice returns.

BTI shares its nice profits with its investors, currently offering a dividend yield of 10%. Based on current earnings per share estimates, this yield is well-covered, with the payout ratio standing at 63%, well below the level seen at peers such as Altria (MO) or Philip Morris.

Takeaway

While buying when the sentiment for a stock is bad and when there’s a lot of fear around isn’t easy, it can be very rewarding. I believe that British American Tobacco is currently trading at a “be greedy when others are fearful” price, offering a hefty dividend yield and an even higher earnings yield. The intangible asset write-down does not impact the company’s cash or cash flows, and with the growth in BTI’s reduced-risk portfolio, some long-term earnings growth seems quite achievable. I increased my position in BTI on Wednesday.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.