Should I buy British American Tobacco (BATS) shares?

I think British American Tobacco (LSE: BATS) shares are looking cheap right now. The stock is trading on a price-to-earnings (P/E) ratio of 8x and has a current dividend yield of almost 8%. 

The stock price performance hasn’t been great. Since the beginning of the year, BATS shares are up over 2% and down nearly 10% over the past 12 months.

The shares are facing some headwinds right now. But as a pure income play, I’d still buy the stock. 

Bull case

I know smoking is bad and so does BATS. So what’s a company to do that has built its business selling tobacco? It focuses on growing its New Category division, which includes vapour products.

The company is encouraging smokers to switch to these “scientifically substantiated reduced risk alternatives”. It’s worth highlighting here that these products are not completely health-risk-free and are also likely to be addictive.

But this has been working so far for the FTSE 100 firm. So much so that the company expects a clear route to profitability for the New Category division by 2025. This should be positive for BATS shares.

It even upgraded its revenue guidance earlier this week. For 2021, it now expects sales growth of more than 5%. This is ahead of its previous forecast of 3%-5%. To me, this clearly demonstrates that momentum across the business is strong.

As I previously mentioned, BATS shares generate a strong yield of almost 8%. This is great for an income-hungry investor like me. What’s even better is that the income is supported by earnings. The dividend cover is 1.5x, which means that if things carry on as they are, the income payments should continue. Of course, this isn’t guaranteed.

Bear case

I do have two main concerns with BATS shares. The first one is regulation. This isn’t going away and, if anything, will only increase. As I said before, this is why the company is backing its New Category division with full force.  

Most governments are introducing measures to discourage smoking, which will likely place pressure on sales and profitability. It’s a headwind for the stock. I guess time will tell whether it can continue to weather the regulatory environment.

My second concern is the net debt position. This is high, but it’s coming down. At the end of 2020, BATS net debt stood at over £40bn. It expects to reduce this by the end of 2021, so that leverage as a multiple of EBITDA is 3x.

To me this is still high, but I guess the main thing is that the company has strong cash flow and is in a position to pay down its liabilities. I shouldn’t forget that this is while it’s paying shareholders an attractive dividend.

My view

BATS shares are cheap and I think the company is taking the right steps to ensure its survival. I reckon the threat of increased regulation and investors seeking out ethical investments are the reasons behind the low valuation.

But with an attractive yield of almost 8%, I’d buy BATS shares as a pure income play. In my opinion, this is a steady stock, which I don’t expect to deliver stellar price appreciation, but I can’t ignore the dividend.