Is British American Tobacco plc A Safe Dividend Investment?

Not all dividends are as safe as they seem. What about British American Tobacco plc (LON: BATS)?

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british american tobacco / imperial tobaccoI reckon, to most investors, the only important thing in cigarette manufacturer British American Tobacco’s (LSE: BATS) (NYSE: BTI.US) recent half-time results is how the firm is doing with cash-generation and debt.

Revenue and profits might be up a bit; the firm might be struggling to overcome currency head winds thanks to the strong pound, but none of those things matter if cash flow is strong and debt’s under control.

After all, tobacco companies operate in an industry with declining volumes even though BATS claims that it’s winning market share within that slipping market. Meanwhile, the firm uses cash flow to finance share buy-backs to drive up earnings- and dividend-per-share figures. When it comes to investor returns, cash is what counts here, so what’s the news?

Cash is down and debt is up

The news is opposite to what we want to see. Net cash from operations is down around 11% on the year-ago figure at £1,170 million. Meanwhile, net debt climbed by almost 4%,  putting the net gearing at about 187%, or around 2.4 times the level of last year’s cash flow.

That situation on cash-generation and debt compares to a recent record that looks like this:

Year to December 2009 2010 2011 2012 2013
Net cash from operations (£m) 3,878 4,490 4,566 4,427 4,436
Net gearing 117% 86% 99% 116% 145%

There’s a clear up-trend in the level of borrowing and a suspicion that cash flow might be on the slide. I’ll be keen to see how the whole year works out. BATS should report its full-year results around 26 February.

Downside risk

British American Tobacco reckons it is making progress on growth in areas such as Asia Pacific, Bangladesh, Pakistan, Indonesia, Brazil and Russia. However, the firm warns that the economic environment across Western Europe remains fragile although some signs of improvement exist.

Putting up charge-out prices seems unlikely to keep revenue increasing indefinitely. I’ve thought for some time that, sooner or later, BATS’s cash flow might slip if tobacco and cigarette sales volumes keep declining.

At today’s share price of 3544p, BATS trades on a forward earnings’ multiple of 15 for 2016. That’s expensive for a firm operating in an industry in decline. A downwards re-rating on valuation could easily nullify investors’ dividend gains, and falling cash flow could be the event that catalyses such a revaluation.

Can an ongoing share buy-back programme keep up for investors? Maybe, but a shrinking business with rising debt is surely vulnerable to downside risk.

What now?

We might think investing to harvest dividends is an easy option on the stock market. It isn’t. All investing is fraught with difficulty and it’s easy to make a lash-up of it, even with a big payer like British American Tobacco.

 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Kevin Godbold has no position in any shares mentioned. The Motley Fool has no position in any of the shares mentioned.

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