The FTSE 100 is full of dividend bargains right now, but one that really stands out to me as being severely undervalued is British American Tobacco (LSE: BATS).
Ethical considerations aside, over the past few decades, this company has earned itself a reputation as being one of the FTSE 100’s most reliable income stocks.
British American’s healthy profit margins and robust cash flows have enabled the group to increase its dividend every year for at least the last two decades. And today, the stock supports a dividend yield of 7.1%, which is set to rise to 7.5% for 2020, according to current City projections.
However, despite British American’s healthy dividend credentials, investors have been selling the stock recently due to concerns about long-term growth potential.
Bleak outlook
There’s no denying the use of tobacco is declining around the world, and this suggests the tobacco industry’s time is limited. But British American and its peers have been investing billions in trying to develop the next big thing that could offset the decline in combustible tobacco products.
The industry had been pinning its hopes on the rise of e-cigarettes but, following a spate of vaping-related deaths in the US, it’s not clear if this will still be the panacea in industry needs.
According to British American’s second-half trading update, revenue growth in its new categories — e-cigarettes, tobacco heating products and snuff — is going to be at the lower end of management’s expectations for the full-year. The company had been forecasting overall revenue growth of 30-50% for this category in 2019.
Beating expectations
While this is disappointing news for investors, the rest of the business seems to be firing on all cylinders. The company announced today that while growth in its new categories was below expectations during the first half of its financial year, the legacy business has outperformed expectations.
Management now believes full-year currency-adjusted revenue growth will be at the top end of its 3-5% long-term target range. The group reckons adjusted earnings per share growth will be in the high-single-digit range.
These figures seem to suggest British American is still in growth mode, even though its new products are not living up to expectations. With this being the case, I think shares in the company look undervalued at current levels.
The stock is currently dealing at a forward P/E of just 9.3, falling to 8.7 for 2020, based on current growth projections. Historically, the shares have changed hands for around 13 to 22 times earnings. On that basis, I think you could make a good argument that the stock is undervalued by approximately 57% at current levels.
The bottom line
If British American continues to outperform expectations, then I don’t think it will be long before this valuation gap closes. And that could happen in 2020 as sentiment towards the business changes.
In the meantime, investors can look forward to that 7.1% dividend yield, which is covered 1.5 times by earnings per share.
