Can British American Tobacco Outperform Philip Morris?

Published in Company Comment on 3 December 2012

We compare British American Tobacco (LSE: BATS) and Philip Morris International (NYSE: PM.US).

If you're interested in building a profitable, diversified portfolio, then you will often need to compare similar companies when choosing which share to buy next. These comparisons aren't always as easy as they sound, so in this series, I'm going to compare some of the best-known names from the FTSE 100 (UKX), FTSE 250 and the US stock market.

I'm going to use three key criteria -- value, income and growth -- to compare companies to their sector peers. I've included some US shares, as these provide UK investors with access to some of the world's largest and most successful companies. Although there are some tax implications to holding US shares in a UK dealing account, they are pretty straightforward and I feel are outweighed by the investing potential of the American market.

Today, I'm going to take a look at the world's two biggest publicly traded tobacco companies, British American Tobacco (LSE: BATS) (NYSE: BTI.US) and Phillip Morris International (NYSE: PM.US). All data is sourced from Morningstar, Reuters and company reports.

1. Value

The easiest way to lose money on shares is to pay too much for them -- so which share looks better value, BAT or Philip Morris International?

ValueBritish American TobaccoPhilip Morris International
Current price-to-earnings ratio (P/E)20.417.9
Forecast P/E15.817.3
Price-to-book ratio (P/B)8.8-101.0
Price-to-sales ratio (P/S)4.14.9

Neither BAT nor Philip Morris look very compelling on a value basis, but BAT is a clear winner nevertheless, thanks to Philip Morris International's negative P/B ratio. This means that according to its most recent results (Q3 2012), Philip Morris' liabilities were greater than its assets. Although these liabilities are cushioned by a giant $4.8bn cash balance -- which compares well to BAT's $1.8bn cash pile -- a negative P/B ratio does not appeal to me, and makes BAT's P/B ratio of 8.8 look relatively good value.

BAT's lower forecast P/E and P/S ratios also look better value, making its revenue and future earnings cheaper than those of Philip Morris International.

2. Income

With low interest rates set to continue for the foreseeable future, dividends have become one of the most popular ways of generating an investment income. How do BAT and Philip Morris compare in terms of income?

ValueBritish American TobaccoPhilip Morris International
Current dividend yield4.0%3.8%
Five-year average historical yield4.3%4.0%*
Five-year dividend growth rate17.7%23.3%*
Forecast yield4.1%3.6%

*Philip Morris International was spun-off from its former parent Altria in 2008, so this average was calculated over four years.

BAT scores a second win here, in my view, as its current, five-year average, and forecast dividend yields are all higher than those of Philip Morris International. Although BAT's dividend growth rate is lower, Philip Morris' dividend history is too short for its superior growth rate to be significant.

For UK readers who are not very familiar with US tobacco stocks, Philip Morris International sells the Philip Morris brands (which include Marlboro) in all markets outside the USA. It was spun off from former parent Altria in 2008, and Altria continues to sell the Philip Morris brands within the US. This divide means that Philip Morris International can benefit from lightly regulated emerging market growth and avoid the heavier, more punitive regulation and lawsuit risks that apply in the US.

3. Growth

Even if your main interest is value or income investing, you do need to consider growth. At the very least, a company needs to deliver growth in line with inflation -- and realistically, most successful companies need to grow ahead of inflation if they are to protect their market share and profit margins.

How do BAT and Philip Morris shape up in terms of growth?

ValueBATPhilip Morris International
Five-year average earnings per share growth rate11.3%10.8%
Five-year average revenue growth rate9.5%9.6%
Five-year share price return73%84%

Philip Morris and BAT are virtually neck and neck here, having delivered near equal earnings and revenue growth over the last five years. However, from an investor's point of view, Philip Morris must be the overall growth winner: it beats BAT on share price growth, having delivered an extra 11% capital gain to its shareholders over the last five years.

In looking at earnings growth, it is worth nothing that both companies have spent billions of dollars on share buybacks in recent years and continue to do so -- Philip Morris International has just commenced a new three-year, $18 billion share buyback program, while BAT is on course to have repurchased £1.25bn worth of shares this year alone. These buybacks boost earnings per share (because there are fewer shares in circulation), but mean that real earnings growth may have been lower than these statistics suggest.

Should you buy BAT or Philip Morris?

Neither BAT nor Philip Morris is a screaming buy at the moment, in my opinion, as both companies have become quite expensive over the last few years thanks to their attractive dividend yields, high profitability and strong earnings growth.

It's worth noting that both companies manage the impressive trick of having both dividend yields and P/E ratios that are above the average for their indices (the FTSE 100 and the S&P 500). To me, this suggests a 'too good to last' scenario and I believe that earnings and dividend growth for both companies may slow over the next few years.

I'm also not a big fan of the costly share buyback programmes on which both companies spend much of their spare cash. These buybacks are being conducted at near-record high share prices and earnings multiples -- to me, this suggests that their primary goal is to inflate future earnings per share figures and thus boost their share prices, rather than providing the best value for shareholders. If I were a shareholder of either company, I would rather see this cash being used to reduce debt and fund special dividends.

If I had to choose one of these stocks to buy, I would pick BAT, thanks to its lower forward P/E ratio, which suggests that the markets believe there is greater scope for earnings growth than with Philip Morris, where the forward P/E is almost identical to the current P/E. BAT's higher yield is also an attraction, but I would not choose to buy either share at their current valuations. I believe that much better value, income and growth is available elsewhere in the FTSE 100. One such example is the share I mention below.

Warren Buffett's FTSE Pick

Billionaire investor Warren Buffett is known for his uncanny ability to spot a bargain and act decisively. After buying quality names at cheap prices during the financial crisis, this year he invested almost $1 billion in one of the UK's best-known blue chip brands -- a FTSE 100 giant in which Buffett now has a 5% stake.

If you'd like to know which UK company tempted the legendary investor to make a rare investment outside the US, then this free Motley Fool report has all the details. What's more, you may still be able to buy the shares Buffett bought at the price he paid! Indeed, the company in question has increased its dividend every year for 28 years and currently offers a yield of nearly 5% -- potentially making the share a very attractive long-term investment for income-seekers.

I think Warren Buffett's latest UK buy is a very appealing investment -- in fact, I own shares in the company myself. So, I'd strongly recommend you click here to download this Buffett report now, while it remains free and available.

> Roland does not own shares in any of the companies mentioned in this article.

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