Tobacco shares often seem out of fashion. That includes UK powerhouse British American Tobacco (LSE: BATS). But judging by the recent price of its shares, they are even more unpopular than normal.
The shares have lately been close to their 52-week low. They have lost 34% of their value over the past five years and now trade on a price-to-earnings (P/E) ratio of just 9. That seems cheap to me.
But while the signs suggest an unloved business, I have recently added some more British American Tobacco shares to my portfolio.
Here are three reasons that persuaded me to make the move.
1. Huge dividend potential
With cigarette smoking in long-term decline in many markets, there is a risk that lower sales volumes will lead to falling revenues and profits for tobacco companies.
However, that has been a risk for decades already. Despite that, British American has raised its dividend annually for decades. Last year it grew by 6%.
The business continues to generate free cash flows in excess of the cost of the dividend. Last year, the company still had £3.1bn of free cash flows even after paying £4.9bn in dividends.
Incidentally, thanks to a share buyback programme, that spend on dividends was almost unchanged from the prior year, despite the 6% increase in the size of the dividend per share.
Given the fall in the British American Tobacco share price, the dividend yield is now 8.8%.
For a FTSE 100 share, that is high. But I see reasons to be optimistic that the business can continue generating free cash flows to support it.
2. Future focus
The company sold over 600bn cigarettes last year. So even though cigarette use is falling in many markets, it remains huge business. That could be the case for some time to come, although there is a risk that regulatory intervention may speed up the demise of smoking.
Even with shrinking volumes though, the company’s stable of premium brands such as Lucky Strike give it pricing power that could help sustain large profits.
Rather than relying on that alone, the firm is forging ahead with its non-cigarette business. That is growing fast and could be a significant future growth driver.
3. Attractive valuation
But what motivated me to buy British American shares this month specifically is their valuation.
The company has recently shifted its focus from share buybacks to debt reduction. I think that is one reason some investors have soured on the shares, as the buybacks had enabled a sizeable per-share dividend increase without costing the company a lot more.
I think paying down debt also makes sense however. Adjusted net debt was £38bn at the end of last year. Servicing that is costly and could become more so as interest rates rise.
Meanwhile, the business remains strong. Paying down debt could help improve free cash flows even more over the long term. I think a P/E ratio of 9 looks cheap for a blue-chip company like this.
