February’s edition of the Morningstar Europe Core Pick List features the most attractively valued European-domiciled companies that possess sustainable competitive advantages. This month’s list saw almost no turnover compared with last month, as the trading-level fluctuations and fair value estimate and moat rating changes in January offset each other.
The only firm to leave our list this month was communication services company Liberty Global, but it has been replaced with one of its peers – BT Group (BT.A).
Our overall list of European stocks under analyst coverage trades at an average of 94% to our fair value estimates.
Liberty Global left the list this month, as the stock appreciated approximately 15% over the past month. While Liberty Global continues to trade in four-star territory, meaning it is undervalued, trading fluctuations across the market caused other names to become cheaper on a relative basis.
British American Tobacco (BATS) and food processor company GEA Group specifically represent some of the cheapest European names on an uncertainty-adjusted, price/fair value basis, currently trading at about a 40% and 30% discount to their fair values, respectively.
Investors Wrong to Abandon BATS say Analysts
Wide-moat stock British American Tobacco is neck and neck with Philip Morris International to be the largest listed global tobacco company: slightly larger than Philip Morris on net revenue, but slightly smaller on volumes.
British American’s global drive brands are Dunhill, Kent, Pall Mall, Lucky Strike, and Rothmans. The firm also sells vapor e-cigarettes, including its Vype brand; heated tobacco, with Glo; and roll-your-own and smokeless tobacco products.
While the stock is not a new addition to the list, we felt it would be a good opportunity to highlight the stock, since it trades at a 40% discount to analyst Phillip Gorham’s £45 fair value.
Gorham forecasts an annual volume decline of 2% on average over the next five years, with price/mix of 5%, a touch below the levels of recent years. He believes a more significant risk to the company’s valuation is the potential ban on menthol in the U.S., which could significantly reduce sales of the company’s Newport brand. However, Gorham believes the firm’s pricing power, which stems from its wide moat will alleviate possible volume declines.
Gorham believes British American Tobacco’s moat stems from its strong franchise in the tobacco industry, formed by the aggregation of intangible assets and a cost advantage. Tight government regulations have made barriers to entry almost insurmountable in the tobacco industry and have kept market shares stable.
Consumers are fairly brand-loyal, particularly in premium-price segments, creating another intangible asset that is no longer as prevalent in other consumer categories. Finally, economies of scale give the large-cap manufacturers an advantage in tobacco leaf procurement and distribution. Gorham’s valuation implies 2019 multiples of over 16 times earnings, 13 times enterprise value/EBITDA, a free cash flow yield of 6%, and a dividend yield of 4%.
These are roughly in line with historical valuations and are sandwiched between those of Philip Morris International, British American’s closest comparable, with slightly higher implied multiples, and Imperial Brands. This is appropriate, in his view, because it reflects the companies’ relative positioning in the heated tobacco category.
