I believe there are good reasons for thinking British American Tobacco (LSE: BATS) offers excellent value for investors right now. So why do I think the FTSE 100 giant has the potential to deliver strong capital gains and a reliable flow of dividends?
Anti-tobacco firebrand
Investor sentiment turned sharply against tobacco stocks through 2018. The threat of regulation is never far from investors’ minds with this industry, but the year saw a run of particularly concerning news coming out of the US. Scott Gottlieb, head of the Food and Drug Administration (FDA) — and its most aggressive anti-tobacco firebrand in decades — ramped up the pressure on the industry:
- In March, he announced he wanted to set a maximum limit on the amount of nicotine cigarettes can contain, which would force tobacco companies to re-engineer their products to make them less addictive.
- In September, he identified what he called a vaping ‘epidemic’ among American teens, and said the FDA would crackdown on e-cigarettes.
- In November, he said he would be moving to ban menthol cigarettes and flavoured cigars from the market, and severely restrict sales of flavoured e-cigarettes in stores and online.
All tobacco stocks suffered under this onslaught, but none more so than British American Tobacco, whose shares slumped more than 50% (from 5,018p to 2,500p) over the course of the year. BAT was particularly badly hit because analysts reckon menthol cigarettes account for about 60% of its US cigarette profits and 25% of the group’s total profits.
Turn of events
Like a number of industry analysts, I’ve been far more optimistic than the market about the impact of any menthol ban (if it actually happens) on the company, due to the likelihood of a considerable migration of menthol smokers to the non-menthol version of the brands. In hammering BAT’s shares, I reckoned the market had way overshot even a worst-case scenario.
Furthermore, Gottlieb’s proposed menthol ban and nicotine-content restriction would take years to enact (if successful) — potentially more than a decade, with inevitable legal challenges from the industry. This would give BAT plenty of leeway to adapt to a new regulatory environment, as it has done successfully to past adverse developments for its business.
The timescale has just been pushed further out — and the proposals may even disappear off the agenda — as Gottlieb announced his resignation as FDA Commissioner on 5 March and is set to depart next month. Tobacco stocks jumped on the day of the news.
Not only can it take some time to appoint a new permanent commissioner (possibly beyond 2020), but also the new head may not make tobacco regulation a signature issue, as Gottlieb did. There are plenty of other potential points of focus to champion, such as lowering the cost of the US healthcare system.
Still a smokin’ buy
BAT’s share price is currently up to 3,150p or so, and while it’s not as cheap as late last year and earlier this year, I think it continues to offer great value at the current level. It trades on 10 times forecast current-year earnings, with a prospective dividend yield of 6.6%. I’d be happy to buy at this valuation.