Are undervalued BATS shares worth over £50?

It's been a grim year so far for British American Tobacco, but the sell-off could be overdone, reports Graeme Evans. 

One of fund manager Neil Woodford's better calls last year was to dump British American Tobacco at £50, having previously reaped the rewards of tobacco's long run as one of the best performing sectors on the UK stockmarket.

By last month, BATS was trading at £36 and at the lowest level since early 2016, driven south by declining volumes and the vow by US health officials to cut nicotine levels in cigarettes. Rival vaping products, such as Juul, have also threatened the dominance of tobacco's Big Four, including Imperial Brands.

However, this share price decline has left BATS looking undervalued in the eyes of some analysts, particularly as the popular income stock yields around 5%.

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UBS pointed out today, in the wake of half-year results, that the company's projected 2019 price earnings multiple of 12.1x represented a 35% discount to European consumer staples and a 18.2% drop to rival Philip Morris. The team at UBS sees no reason why the company can’t return to £50 and beyond, with a price target of £56.50. The stock was 5% higher at £41.60 today.

Last month, Liberum initiated coverage of Imperial and BATS with buy ratings and said the latter's strong portfolio of brands - Dunhill, Kent, Lucky Strike, Pall Mall and Rothmans - was a good reason to expect further margin improvement. 

Source: interactive investor      Past performance is not a guide to future performance

However, much is likely to depend on the impact on US profits if a new nicotine standard is introduced, as many expect, by 2021.

BATS increased its exposure to the US market last year when it bought the remainder of Reynolds to become the world’s biggest tobacco company. As well as adding the brands Newport, Camel and Natural American Spirit, the deal helped to accelerate BATS' development of e-cigarettes and vapes.

Since 2012, BATS has invested US$2.5 billion in next generation products, including the glo tobacco heating brand and vapes under the Vype name.

Chief executive Nicandro Durante says the company remains on track to exceed £1 billion of reported revenues in next generation products in 2018. That was slightly more reserved than his guidance last month for "substantially more than £1 billion". By 2022, he wants to have increased the figure fivefold to £5 billion.

The caution reflects a recent slowdown in the tobacco heating market in Japan and South Korea, where the company sells the glo device. UBS said it was relaxed about the latest guidance, given that it is still in line with consensus.

They added that adjusted earnings of £4.82 billion were 1-2% ahead of forecasts, albeit down 5.4% on a year earlier based on current exchange rates.

BATS pointed out today that its cigarettes and tobacco heated products outperformed the industry in the half year, with market share growing 40 basis points.

Its record of dividend growth is one of the best in the FTSE 100 index, stretching back as far as 1999. Increased access to group cash flows should provide further support to the company’s commitment to a dividend payout ratio of at least 65% of earnings. 

The next quarterly dividend payment of 48.8p will be made in August, as part of the previously announced annual dividend of 195.2p per share.