Over the past 12 months, shares in FTSE 100 dividend stalwart British American Tobacco (LSE: BATS) have slumped 33% excluding dividends, underperforming the UK’s leading index by a staggering 36%.
This is one of the worse performances British American has registered in its long history, and many investors are now asking if the company’s time is up. However, I believe the opposite is true, and now could, in fact, be the time to buy.
Deteriorating outlook
British American isn’t the only tobacco stock underperforming in 2018. Virtually all of the company’s global peers are lagging the market because investors are becoming concerned that the industry is living on borrowed time.
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Big tobacco has been pinning its hopes for growth on so-called Next Generation Product (NGP) products, such as e-cigs and heat-not-burn technology. This category expanded rapidly at first, although growth is now slowing, and the City is becoming concerned that investments in these products won’t save the industry’s bacon.
Analysts’ concerns were validated earlier this week when British American confirmed a slowdown in the Japanese heated tobacco market. Although sales are still expanding, and the firm’s glo product has a 4.3% market share, the company’s slowdown warning did little to reassure investors. Nonetheless, the group continues to target “substantially more than £1bn” in NGP sales for 2018 as it rolls out products in other markets.
£1bn in NGP sales is hardly small change, but with British American’s legacy tobacco industry in terminal decline, it seems investors are not willing to give the tobacco behemoth the benefit of the doubt.
In my opinion, the lack of growth is just part of the puzzle. Valuation has also had a role to play.
Too cheap to pass up?
As one of the FTSE 100’s top defensive income stocks, investors have rushed to buy shares in British American over the past decade to make up for the lack of income available elsewhere. Demand pushed the stock’s valuation up to a high of 22 times historic earnings last year and the dividend yield down to 3.4% in 2016.
Now interest rates are rising, it seems income hunters are no longer interested in what the firm has to offer.
But they should be. Recent declines have pushed the dividend yield on the stock up to 5.7%, and the shares now trade at a forward P/E of 11.9. According to data from Morningstar, this is the highest yield and lowest valuation the shares have offered in a decade.
Sceptics might argue that, looking at the current state of the tobacco market, the shares deserve this depressed valuation. However, I would say that the tobacco market has been in decline for decades and despite these headwinds, British American has seen earnings per share increase from 145p in 2010, to 327p for 2017.
To put it another way, it has been shrouded by concerns about the bleak outlook for tobacco for many years, but that hasn’t stopped the shares producing a total return of 15% per annum for investors over the past 15 years — one of the best performance records around.
In my opinion, this trend isn’t going to come to an end any time soon.
