A recovery play to buy with a solid yield

Let’s start with a health warning about this stock. It falls within the category of so-called “sin” stocks. It makes and markets products that many people dislike intensely. And it goes against the grain of modern medical opinion. We’re not here, though, to make moral judgements about portfolio selections. Our job is to highlight interesting investment opportunities, while leaving the decision-making up to you. 

So here goes. British American Tobacco, known as BAT (LSE: BATS), is a very cheap share. Yet as its name implies, the company’s main business is selling “combustible” (ie, conventional) cigarettes. 

And to be clear, “there is no safe level of tobacco consumption”, as Australia’s Department of Health puts it. “All tobacco contains nicotine and other toxic chemicals. Even if you don’t breathe in the smoke, you absorb harmful chemicals through the lining of your mouth.” 

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BAT agrees that combustible cigarettes pose “serious” health risks and that “the only way to avoid [them] is not to start, or to quit”. Furthermore, the company does “encourage those who would otherwise continue to smoke to switch to scientifically substantiated, reduced-risk alternatives” – more on these later.

Despite all the warnings, however, there are 1.1 billion smokers worldwide, while another 200 million people use other tobacco products, according to the Tobacco Atlas produced by global public health organisation Vital Strategies and the Tobacconomics team at Chicago’s University of Illinois. The planet’s population of roughly eight billion people consumes almost five trillion cigarettes each year. 

A recovery play to buy with a solid yield

BAT is one of the largest players in the sector, operating in more than 170 markets,
with 41 cigarette-making facilities in 39 of these. Over the long term, it has consistently managed to grow sales, cash flow and profits. Indeed, last year the group sold 605 billion cigarette sticks and 16 billion other tobacco products (OTP), including cigars and chewing tobacco. Total revenues reached £27.7bn, of which 45% came from the US; 83% of sales were from combustibles as opposed to smokeless products. However, the company has stressed that its “purpose is to reduce the health impact of our business by offering a greater choice of enjoyable and less risky products for our consumers”.

In 2013 BAT introduced the first of its Vapour products to the UK. These are handheld, battery-powered devices that heat an “e-liquid” to produce inhalable aerosols. People vape to help cut down on, or quit, cigarettes. In 2016 in Japan, the group launched its initial tobacco-heating product (THP). These heat rather than burn tobacco, creating an inhalable aerosol containing nicotine. The following year, “modern oral products” (smoke-free oral nicotine pouches) appeared.

However, as the above items contain nicotine, which is highly addictive, some health concerns remain that could hit the company’s future sales. Other longer-term revenue risks are increased illegal competition, potentially higher tax on tobacco-related products, and the possibility of product-liability litigation. 

Meanwhile, California has become the second American state to ban all flavoured tobacco product sales, following the lead of Massachusetts in 2019. The US Food and Drink Administration (FDA) is also planning to ban menthol as a cigarette flavour.

More recently, BAT’s CEO has admitted that “our performance in US combustibles has been disappointing”. Against this backdrop, BAT’s stock price has been in retreat in recent months. It has more than halved since its peak of just over six years ago. Indeed, over the past 12 months, it has slipped by about 24%. However, that has left shares in this industry leader very cheap with a juicy yield, as we explain below.

All the risks are in the price 

In the six months to 30 June 2023, BAT reported revenue up 4.4%, 16.6% of which came from non-combustibles. Adjusted profit rose by 3.6%, with the adjusted operating margin at 44.3%. Adjusted diluted earnings per share (EPS) climbed by 5.3%.

The improved performance “in the critical premium US combustibles business since January 2023 is encouraging”, says the company. The forward price/earnings (p/e) ratio to 31 December 2023 is 6.75, according to consensus estimates. For 2024 and 2025, the forecast multiple drops to 6.4 and below six. In addition, the price-to-book value is just 0.83. In other words, this stock is dirt cheap.

Then there’s the whopping payout to shareholders. In February 2023, the company announced a 231p per share dividend for 2022, payable in four equal quarterly instalments in May, August and November 2023 and in February 2024. These comprise an overall yield of 9%. Generally, a return this high indicates that a reduction in the dividend may be on the cards soon. 

That could still happen in BAT’s case: after all, the group has net debt of £38bn.
Yet with profits and cash flow historically proving very resilient, and the current distribution covered 1.65 times by the 2023 consensus forecast of EPS, the dividend looks fairly secure. 

In short, there’s a strong value case for buying into BAT. While the shares are risky, at the extremely low current valuation the dangers appear to be fully factored into the price. BAT has often traded on a p/e between 15 and 20, so there’s scope for significant upside on any recovery in sentiment. Even better, with that very high yield, investors are being well paid to wait until this happens.