British American Tobacco Remains Undervalued

Following the recent court case against the tobacco industry in Canada, equity analysts retain BAT's fair value estimate of £37.50

Philip Gorham 10 June, 2015 | 11:47AM
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The Quebec superior court has awarded punitive damages to former smokers against British American Tobacco (BATS), Philip Morris International (PM), and Japan Tobacco (2914) on the grounds that tobacco manufacturers concealed the risk of smoking. Litigation like this is not new, and neither is the award's magnitude. Last year, the widow of a former smoker in Florida was awarded $23.6 billion in damages from Reynolds American Tobacco, a judgment that is currently being appealed.

We believe the size of the damages will be lowered 

Large awards such as this, both in the tobacco industry and outside, are often revised significantly downward during the appeals process. The Engle class action suit, which awarded $145 billion in punitive damages against the industry in 2000, was decertified and the award set aside in 2006.

If paid today, the award against BATS would require a further £5.5 billion in debt, assuming its cash balance was maintained, which implies an increase in the debt/EBITDA ratio to 3.1 times from 2.4 times. We estimate it would have a negative impact on our valuation of 100p or 3% of our fair value estimate. With a multiyear appeals process to come, the ultimate timing and magnitude of any award could result in a more muted impact to the intrinsic values of the tobacco firms.

We are maintaining our £37.50 fair value estimate for British American Tobacco and $92 fair value estimate for Philip Morris International following the recent award against the tobacco industry in Canada. The defendants will appeal the judgment, making the timing and magnitude of any final award highly uncertain.

We believe there is a strong possibility that the size of the damages will be lowered during the appeals process. Thus, we doubt that excess returns on invested capital will evaporate as a result of this particular judgment, and we are reiterating our wide moat ratings for both BATS and PM.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
British American Tobacco PLC3,138.00 GBX-0.19Rating
Japan Tobacco Inc2,351.00 JPY-0.28Rating
Philip Morris International Inc103.38 USD1.25Rating

About Author

Philip Gorham