Will FTSE 100 income champ British American Tobacco thrive in 2019?

Last year, one FTSE 100 stock performed significantly worse than every other index constituent, sliding 46% throughout the 12-month period, underperforming the broader index by 37.2% when including dividends.

Unfortunately, for shareholders of British American Tobacco (LSE: BATS) this performance wiped out a decade of market-beating gains. 

Heading into 2018, the stock had outperformed the FTSE 100 over the previous decade by a high single-digit percentage on an annualised basis. Now, after losing nearly 50% of its value in just 12 months, over the past 10 years, holders have seen a total return of 7.7% per annum, compared to 8.8% for the FTSE 100, an underperformance of 1.1% a year.

The question is, why did British American slump in 2018 and will this trend continue or reverse in 2019?

Multiple headwinds

With governments around the world set on stamping out smoking as part of a global drive to improve public health, there have been question marks hanging over its business model for some time.

However, in an attempt to offset these concerns, the company has been working flat out to develop and increase sales of so-called reduced risk products, such as heat-not-burn cigarettes and e-cigarettes. This strategy seemed to be working until early 2018 when suddenly, sentiment towards these reduced risk products changed. Sales growth started to slow, and regulators announced that they would be paying more attention to them going forward. 

At the beginning of 2018, British American was viewed as a company that offered the best of both worlds. An attractive, well-covered dividend yield and the potential for growth through the development of those reduced risk products. 

Investors rushed to buy into this rare combination of income and growth, paying a premium to do so. At one point in 2017, the shares were changing hands at 23.5 times forward earnings. 

Crashing back to earth 

The situation has changed dramatically since 2017. With sales of the reduced risk products slowing, and sales of traditional cigarettes declining at an ever increasing rate, British American no longer looks like a growth investment and some analysts are now starting to question if the company’s formerly gold-plated dividend is sustainable.

In my view, a P/E of 23.5 was never a sustainable valuation. I reckon a multiple of around 13 is more suitable, which implies a share price of 3,783p (City analysts are currently forecasting earnings per share (EPS) of 291p for 2018). 

When it comes to the dividend, there is a chance the distribution could be cut as the firm has quite a lot of debt, which it built up when it acquired its American peer Reynolds American in 2017. 

That being said, the distribution is currently covered 1.5 times by EPS, so I don’t think there is an immediate threat. The dividend yield of 8% looks to be here to stay for the near future. 

The bottom line 

Overall, after considering all of the above, I think British American looks undervalued at current levels and with this being the case, I think the shares could bounce back in 2019.