Historically, shares in tobacco companies have been considered to have defensive properties. Earnings should be more resilient to an economic downturn due to the addictive nature of their products. With the UK in recession, these are the types of stocks that I’m looking to add to my portfolio. I’m wondering whether I should buy British American Tobacco (LSE:BATS) shares.
The BAT share price has out-performed the FTSE 100 over the past year. The stock of the UK’s seventh-largest listed company has risen by close to 30%. In contrast, the Footsie has increased by less than 2%.
Despite its impressive performance over the past 12 months, I fear that the share price may be about to run out of puff.
Going up in smoke
In 1974, according to the Office of National Statistics, 45.6% of the UK adult population smoked. This has now fallen to 14.5%. It’s clear that the challenge for tobacco companies is to find alternative markets to cigarettes.
BAT claims to be “building a better tomorrow” by diversifying into non-combustible products. These new categories contributed £1.3bn of the company’s £12.9bn revenue in the first half of this year. The aim is to grow these sales to £5bn by 2025.
Vapour revenue was up 48% and sales of oral pouches increased by 37%. Consumers of these products rose by 2.1m to 20.4m. The proportion of revenue generated from products other than cigarettes was 15%.
However, in spite of this impressive growth, these new revenue streams are still loss-making.
And, investing in alternative markets doesn’t come cheap. The company spent £1.1bn in the first half of the year developing its next generation of products.
BAT’s net debt at 30 June 2022 was £40.0bn, compared to £40.5bn a year earlier. This equates to approximately three times EBITDA (earnings before interest, tax, depreciation, and amortisation). A ratio over three is considered to be on the high side for a listed company.
One point to note is that BAT is currently being investigated by the US government for a breach of sanctions. Although a provision of £450m has been made in its accounts to cover a potential settlement, this may not be enough.
But, the company continues to generate huge amounts of cash. This means it’s able to pay a healthy dividend to shareholders. The dividend yield is currently 6.6%, compared to the average for the FTSE 100 of around 4%.
The verdict
I wouldn’t be comfortable investing in BAT at the moment.
The long-term prospects for vaping, tobacco heating, and nicotine pouches are not yet clear. The World Health Organisation has described e-cigarettes as “harmful“. It has also called on governments to “implement regulations to stop non-smokers from starting to use them“.
I fear that increasingly cash-strapped governments may view these products as an easy target for new or increased taxes.
I believe the new generation of products that BAT is investing heavily to promote, will fall out of favour, just like cigarettes.
Despite the healthy dividend, I think there are better opportunities elsewhere.
