Investors in British American Tobacco (LSE: BATS) (NYSE: BTI.US) have seen their shares and their dividend payouts double in value since August 2007, during which time the FTSE 100 has gained just 6%.
This kind of performance is impressive by any standards, but is especially good given that the tobacco industry is supposed to be in a long-term decline — so what’s going on?
The world’s most profitable industry?
One of the benefits of selling a mature product like cigarettes is that you don’t have to spend much money on R&D. Your customers are already addicted, and do not want or expect anything to change.
BAT owns several of the world’s biggest cigarette brands, and smokers in emerging markets will pay a premium for these brands, allowing BAT to take market share from local brands, without sacrificing pricing power — the holy grail of profitability.
During the first six months of this year, BAT’s operating margin rose to 37%, up from 35.3% last year. The firm targets a 0.5-1.0% increase in operating margin each year, and margin growth, coupled with share buybacks, have enabled BAT’s earnings per share to rise steadily, despite falling volumes.
Of course, the process of extracting more profit from fewer sales will reach a limit eventually, but BAT sold 694bn cigarettes last year, so I don’t think it’s anywhere near the limit yet.
A replacement for tobacco?
Electronic cigarettes — also known as vaporisers — have become increasingly popular in western markets over the last few years.
To be honest, I didn’t realise just how popular they had become until I saw a statistic in the Financial Times last week, suggesting that 10% of the UK’s 10m smokers now like to ‘vape’ — inhale nicotine vapour from an electronic cigarette.
BAT has been investing in electronic cigarettes for some time, and has recently launched its own product, Vype, into the UK market.
Vaping is no less addictive than smoking, and currently has none of the troublesome regulatory restrictions that apply to selling cigarettes and smoking. You can, for example, sit inside a pub and vape, quite legally.
I’ve got a feeling that this could become a very big market indeed.
BAT shares are still a buy
Despite their fantastic run over the last decade, I believe that British American Tobacco shares still have further to run, especially in terms of income growth.
I’m not alone, either. One of the most successful UK fund managers of the last two decades, Neil Woodford, has stayed loyal to the tobacco sector despite its outperformance.
Indeed, if you’d invested £10,000 into Mr Woodford’s High Income fund in 1988, it would have been worth £193,000 at the end of 2012 — a 1,830% increase!
British American Tobacco is one of Neil Woodford’s largest holdings. If you’d like access to an exclusive Fool report about Mr Woodford’s eight largest holdings, then I recommend you click here to download this free report, while it’s still available.
> Roland does not own shares in any of the companies mentioned in this article.
