After a rather disappointing 2013, British American Tobacco (LSE: BATS) (NYSE: BTI.US) has struggled to keep pace with the FTSE 100 in 2014. Indeed, shares are currently down 0.5%, while the index is up 1%.
The reason for this seems unclear. Certainly, British American Tobacco is reliant to a fairly large extent on emerging markets for its sales. Therefore, it is perhaps understandable that it fell more than the wider market when concerns surfaced surrounding the sustainability of the emerging market growth story.
However, British American Tobacco’s revenues are, by nature, very stable and people are unlikely to stop smoking as a result of a lower growth rate in GDP. Therefore, is a poor 2013 (when shares lagged the FTSE 100 by 10%) and a slow start to 2014 a result of concerns surrounding the sustainability of British American Tobacco itself? In other words, is British American Tobacco dependent on debt?
Excessive Debt?
With a debt to equity ratio of 169%, British American Tobacco appears to have excessive financial gearing levels. Indeed, with every £1 of net assets (total assets less total liabilities) being matched by £1.69 of debt, the company is highly leveraged. However, two factors mean that relatively high debt levels are manageable.
Firstly, British American Tobacco sells a product that enjoys a very stable revenue stream. Therefore, even if the world economy experiences another recession, tobacco sales should hold up well. A stable revenue stream means that a greater amount of debt can be accommodated on the balance sheet, since interest payments can be made with more certainty.
Secondly, British American Tobacco is highly profitable and is currently able to service its debt levels with considerable headroom. Indeed, its interest coverage ratio is 11.9, which means that it was able to pay its net interest nearly twelve times with operating profit last year. A level this high means that debt levels are currently very manageable.
Looking Ahead
Although earnings per share (EPS) are set to grow by just 1% in 2014, British American Tobacco is expected to return to above-average levels of growth in 2015, when EPS is forecast to increase by 9%. This, combined with a comfortable level of financial risk and the aforementioned stable revenue stream, mean that British American Tobacco could undo the disappointment of 2013 and finish the current year ahead of the wider index.