Shares in FTSE 100 income champion British American Tobacco (LSE: BATS) have slumped by nearly 18% this year, underperforming the UK’s leading blue-chip index by 11%, excluding dividends.
It is difficult to pinpoint precisely why the shares have produced this year-to-date decline, although I believe there are several contributing factors which, when combined, have pushed the stock down.
Multiple factors
British American isn’t the only dividend champion to have seen its stock underperform in 2018. There’s been broad-based selling of dividend stocks so far this year as investors rotate away from these bond-proxies into more traditional income investments, such as bonds. Higher interest rates in the US are the primary catalyst for this shift. With further interest rate increases expected throughout 2018, it doesn’t look as if this trend is going to end anytime soon.
The recovering value of sterling is proving to be another headwind. Following the acquisition of Reynolds American, a significant proportion of British American’s revenue now comes from the US. As the value of sterling fell following the Brexit referendum, companies like British American benefited from this weakness as it meant earnings, when translated back into pounds from dollars, increased.
For example, for full-year 2017, the company reported adjusted diluted earnings per share growth of 14.9% including the benefit of sterling’s depreciation. Excluding this benefit, at constant currency, earnings only increased 9.9%.
Thanks to this headwind, City analysts are expecting the firm’s earnings per share to decline by 7.3% for 2018 before returning to growth in 2019– assuming there are no substantial moves in the value of the pound over the next two years.
Time to buy?
Despite British American’s underperformance this year, I still believe that the stock is a great long-term investment. The company has an unblemished dividend history and, after recent declines, currently supports a dividend yield of just under 5%, with the payout covered 1.5 times by earnings per share.
What’s more, recent declines have pushed the stock down to a valuation close to its historical average. The company’s forward P/E ratio hit a high of 24 last year, but today it’s trading at just 13.4 times forward earnings, near the bottom end of its five-year range.
On an enterprise value to earnings before interest tax depreciation and amortisation basis (EV/EBITDA), the shares are trading at a ratio of 4.7. That’s around half the global food and tobacco sector average.
Terminal decline?
But what about the headwinds facing the business? Well, while it’s true that sales of British American’s primary product, cigarettes are in terminal decline, the company has been investing heavily in reduced risk products and so far, they seem to be picking up the slack.
Last year, the overall cigarette market saw a decline in the number of sticks sold of 3.5%, which was more than offset by price increases. While the company cannot go on increasing prices forever, I believe it will be many years before British American’s business model breaks down.
So overall, I believe the recent declines in the company’s share price are an excellent opportunity for value income seekers to buy.
