The British American Tobacco (LSE:BATS) share price has tumbled over the last 12 months. Having traded at around 3,220p a year ago, the stock is now priced at around 2,710p. That’s a decline of about 16%. While this is nowhere near as large as its crash seen in 2018, it’s still notable. But is this a case of investors being overly cautious? And if so, is the BATS share price trading at a discount?
Is the BATS share price too low?
I’ve actually previously explored the possibility of the BATS share price being too cheap. As a quick reminder, looking at the business’s overall performance, 2020 revenue came in flat. But due to margin improvements, operational profits rose by 10%, more than sufficient to cover debt obligations as well as maintain its substantial dividend yield.
Since then, there has not been much new information published by British American Tobacco’s management team beyond dividend announcements. So why am I looking at this company again? A study into tobacco consumption was recently published that revealed some interesting news for this business and its shareholders.
Despite the efforts made by governments to discourage smoking over the last decade, the level of consumption has never been higher. The study showed that at the end of 2019, roughly 1.14bn people around the world were active smokers. What’s more, this figure could continue rising by around 10% a year due to rapid population growth.
Before investing in any business, I look specifically for certain competitive advantages that will allow it to thrive over the long term. And in the case of British American Tobacco, it has an incredibly addictive product that continues to attract new customers every year. This makes me believe the current BATS share price is still a bargain with its 8% dividend yield.
The regulators are coming
Both the 2018 and 2020 drop in the BATS share price appear to be primarily linked to fears of increased regulation. And I think investors are right to be concerned. It’s no secret that smoking is an unhealthy habit. And the previously mentioned study revealed that in 2019 alone, smoking killed more than 8 million people. To put that in perspective, Covid-19 has resulted in 3.5 million deaths so far.
To make matters worse, the vast majority of smokers becoming addicted today are between the age of 15 and 25. Consequently, regulators have begun exploring new restrictions to limit the amount of nicotine in cigarettes. Given this substance is what makes these products so addictive, any limitations would likely have an adverse impact on future revenues.
The management team has begun exploring alternative products that don’t carry the same level of health risks. If, or more likely when, these new regulations come into force, British American Tobacco should be able to adapt. But currently, 88% of the firm’s income originates from the sale of cigarettes. Suppose these new laws come into force in the next year or so? This may not be enough time for the business to transition. Therefore in that scenario, I think the BATS share price is likely to drop once again.
In its current state, British American Tobacco looks like an undervalued income gem. But add in the looming regulatory threat, the valuation may not be as attractive as it seems. For now, I’m going to be cautious and look for income opportunities elsewhere.
