Why I think this FTSE 100 stock yielding 7% is undervalued by 60%

If you are looking for FTSE 100 income stocks, I don’t think you can go wrong buying global tobacco giant British American Tobacco (LSE: BATS). 

Ethical considerations aside, over the past few decades, British American has proven to investors that it’s one of the best blue-chip income stocks around with steady earnings and dividend growth. 

Indeed, over the past six years alone, the company’s dividend per share has risen at a compound annual rate of around 6.5% as management has increased at the distribution in line with earnings growth. This means dividend cover has remained constant at approximately 1.5 times since 2012.

City analysts expect this trend to continue. They’ve pencilled in dividend growth of 7.2% for 2019 and 5.4% for 2020. If the company achieves these forecasts, investors buying today can look forward to a dividend yield of 7.4% next year. At the same time, analysts have pencilled in earnings growth of 15% for this year and 7% for 2020, leaving shares in the tobacco giant trading at a 2020 P/E of just 8.9 — compared to the five-year average of 15.4.

Growing concerns 

Investors have been selling shares in British America recently because they are concerned about the company’s future. Specifically, analysts are starting to fret that the group is going to run out of room to grow in the near term as policymakers around the world become more aggressive in trying to stamp out smoking.

The firm had hoped to offset falling sales of traditional cigarettes by growing revenues of its so-called reduced risk products, but earlier this year, management informed the market that growth in this area would not be as robust as they might have hoped, confirming suspicions which have been circling for some time. If sales do start to decline dramatically, then the company could be facing big problems. 

Some cracks are already beginning to show across the business. Earlier this week, the company decided to put its Canadian subsidiary into insolvency administration following a ruling against the tobacco industry in Quebec. The subsidiary had been liable for a £5.2bn, and the overall group has already taken a £436m charge in relation to this ruling. 

The decision to place the Canadian ops into administration will cap further losses, but it also means British American will not be able to take cash out of Canada for the foreseeable future. Analysts believe the country contributes less than 4% of the overall group’s underlying earnings.

Navigating stormy waters 

Despite all of the above, I still think that BAT shares are undervalued. Lawsuits and speculation that governments will stamp out smoking for good are nothing new. Analysts have been warning about these problems for the past several decades and, so far, companies like this have adapted well to the changing environment. 

So, while there may be some upheaval for the group in the near term, in my view, as long as management doesn’t make any reckless decisions, I think the company will continue to generate attractive returns for investors over the long term. 

And when confidence returns, I can see the stock trading back up to its five-year average valuation of 15.4 times forward earnings, implying an upside of 60% from current levels. There’s also that 7.1% dividend yield on offer while you wait.