British American Tobacco (LSE: BATS) shares have had a torrid 18 months. Back in June last year, the tobacco giant’s share price was up above 5,600p. Now it’s under 2,800p, so the FTSE 100 stock (which is considered to be ‘defensive’) has lost around 50% of its value.
A little over a month ago, I penned an article that looked at three reasons why BATS shares have fallen. However, since then, the stock has fallen even further, and on Monday it tanked over 10%. So what’s going on and do I think investors should be concerned?
Menthol Ban
The reason BATS shares have fallen this week is that last weekend, the Wall Street Journal published an article saying the US Food and Drug Administration (FDA) is proposing a ban on the sale of menthol cigarettes.
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The news has been confirmed, with the FDA stating it would seek a nationwide ban and also restrict the sale of flavoured e-cigarettes in an attempt to moderate youth smoking. The federal agency believes menthol cigarettes (which account for around a third of the 250bn cigarettes sold in the US annually) pose a greater health risk than regular cigarettes because they are harder to quit.
A lot at stake
This proposed ban on menthol cigarettes is definitely not good news for British American Tobacco as the group generates a significant proportion of its earnings from menthol products. Indeed, it spent $50bn three years ago to acquire Reynolds American, and menthol products represented around 50% of Reynolds’ revenue in 2016, due to the strength of its Newport brand. According to Barclays Capital, British American Tobacco generates approximately 25% of total earnings from menthol.
So is it game over for British American Tobacco shares?
Higher-risk dividend stock
To my mind, this kind of regulatory inference certainly adds risk to the investment case for BATS, and makes the FTSE 100 dividend stock a higher-risk play. Regulatory bodies are clearly serious about trying to curb smoking rates, and this adds considerable uncertainty for both the company and investors.
That said, it may not be game over for BATS just yet. Here are three reasons why.
First, if menthol products were banned (it’s not certain yet), many of those who smoke them may simply switch over to regular cigarettes. Therefore, the damage for BATS may not be as bad as some fear.
Second, while many people are dumping tobacco stocks because of concerns that smoking rates are declining, it’s worth noting that the pace of decline is actually slowing, according to the World Health Organisation. And with fast population growth across Asia and Africa, the number of smokers in these areas is actually forecast to increase in the years ahead, which may offset the reduction in demand across developed countries.
Third, BATS has invested heavily in Next Generation Products (NGPs) which are believed to cause less harm to users, and this segment should continue to grow in the years ahead, offsetting slowing sales from traditional products.
Looking at the valuation, BATS currently trades on a forward P/E of just 9.6 and offers a prospective yield of 7.1%. There’s no doubt those metrics look cheap, but I think it’s fair to say that the stock has now become a higher-risk play due to regulatory uncertainty.
