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Is It Time To Sell British American Tobacco plc And Buy Reckitt Benckiser Group Plc or Diageo PLC?

There are two kinds of stocks: those offering a steady income stream — of which British American Tobacco (LSE: BATS) is a good example — and those promising a steady growth rate, but a lower yield, such as Reckitt  (LSE: RB). And then there’s Diageo (LSE: DGE), which is neither fish nor fowl at present, and sits between the two  — as a result, it’s my least favourite name here. 

Strong performance

I would not sell the shares of British American Tobacco following a strong performance over the last few weeks of trading. Rather, I’d add BATS stock to my portfolio at 3,700p a share. 

If the tobacco maker meets realistic 2017 estimates of 241p for earnings per share (EPS), its EPS will have grown at a decent compound annual growth rate (CAGR) of 4% since 2012, but its dividend per share will have recorded a faster growth rate over the period (one percentage points more), which is essentially why you’d want to hold onto its stock over the long-term. 

Furthermore, its core free cash flow yield at 4% suggests that BATS could raise its payout ratio at a faster clip in the near future, which would boost the value of its stock price, of course. The shares of BATS are not far away from their record highs, and they currently trade at a relative valuation that signals possible upside of between 12% and 18% to the end of next year. Its dividend is covered by earnings. 

There are obvious regulatory risks in the tobacco industry, but BATS is well placed to cope with them. 

Incredibly solid

If you buy the shares of Reckitt, you’ll likely invest in a company that is expected to deliver a CAGR for earnings and dividends in the region of 7% over the next couple of years, backed by a CAGR for revenue of 4%. For all this, you are asked to pay about 25x for 2015 and 2016 earnings, but efficiency measures could render Reckitt more profitable, which means that its stock could be much cheaper than its current and forward multiples indicate.

Its balance sheet is incredibly solid, and a strong capital position leaves plenty of room for shareholder-friendly activity. 

Alliance News reported today that “the UK’s competition regulator (…) will force Reckitt to licence the K-Y brand to a UK competitor for eight years,” which admittedly is not great news, but weakness in its stock price should also be attributed to broader market volatility spurred by China’s devaluation. 

Reckitt remains one of my top picks, and one with a forward yield at 2%, although its current share price of 5,966p is in line with the average price target from brokers, according to estimates from Thomson Reuters. 

Value destruction

I am not interested in Diageo because I do not think that its management team has delivered on its promises since early 2013. Challenging market conditions in the global booze industry are only partly to blame for value destruction over the period, in my opinion.

Additionally, its medium-term CAGR for forward EPS, which is about 3%, indicates that its dividends will have to grow at a much lower pace than 5% on a CAGR basis, according to my estimates. 

I struggle to see why anybody, really, would pay 20x forward earnings for Diageo when it could pay 18x forward earnings to buy BATS, which offers a similar growth rate, but more stable earnings and a forward yield that is almost one percentage point higher than Diageo’s. The shares of these two companies are similarly priced based on their adjusted operating cash flow multiples, which indicate, once more, that Diageo stock is overpriced by about 10%–15%, in my view. 

Also consider that Diageo’s underlying growth rate could diminish, and I’d surely bet on that. Its free cash flow yield is in line with that of BATS, but f I am right, its shares will end up trading more closely to the relative valuation of Reckitt than to that of BATS, although the former belongs to a completely different league!

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.