British American Tobacco (LSE: BATS) shares have endured a stunning collapse over the last 16 months or so. Back in early 2017, BATS was a FTSE 100 stock that everyone wanted to own, and its share price was up to the mid-£50s. At the time, investors were willing to pay P/E ratios of over 20 for the stock. However, fast forward to today, and the shares trade for under £33, a decline of over 40%. So why have the shares fallen?
Bond proxy
For starters, BATS is one of those stocks that many investors classify as a so-called bond proxy. Investors flocked to it for its regular bond-coupon-like dividend payments when bond yields were low, yet with bond yields now rising in the US, they’re dumping the stock because they see bonds as a safer way to obtain yield.
Tobacco is out of favour
Second, the tobacco sector is really out of favour at the moment. BATS certainly isn’t the only tobacco stock to be sold off recently. FTSE 100 rival Imperial Brands has been dumped by investors too, as have US rivals Philip Morris International and Altria Group.
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There are several reasons the sector is out of favour. One is that smoking rates are declining across the Western world and that adds risk to the long-term investment case. Another is that governments around the world are cracking down on the so-called reduced risk products, which were meant to be the next big thing for the industry. And value stocks are very unpopular at present as so many investors are chasing growth. Lastly, some investors, such as Dutch insurer NN Group, are exiting the sector for ethical reasons.
High debt
Third, after the acquisition of Reynolds American last year, BATS now has significantly more debt on its balance sheet. Total long-term debt on its books has surged from £16.5bn at the end of 2016, to £44bn at the end of 2017, which adds further risk to the investment case, particularly in a rising interest rate environment.
So overall, there’s a fair bit of uncertainty in relation to the long-term outlook for tobacco stocks at present. But after a 40% share price fall, does the stock now offer value?
Investment case
Personally, I haven’t invested in BATS up to now simply because I have a sizeable holding in rival Imperial Brands and I don’t want to be overexposed to the sector. However, when I look at the 6% yield on offer from the tobacco giant right now, I have to admit, the stock does look mighty tempting.
Going back to the bond proxy issue, I don’t think a stock like BATS should be compared to a bond, simply because the company has an outstanding track record of lifting its dividend. For example, over the past decade, the company has lifted its payout at a compound annual growth rate (CAGR) of 11.4%. When you consider that coupons from standard bonds are ‘fixed’ and don’t rise over time, it becomes clear that the stock is nothing like a bond.
Of course, there are plenty of risks to the investment case. Declining smoking rates, political intervention and high debt all add risk. Yet with the stock trading on a forward P/E of just 11.3 and offering a prospective yield of more than 6%, the risk/reward profile looks attractive, in my view.
