It’s been a rough 12 months for the British American Tobacco (LSE:BATS) share price. Despite being one of the leaders in the tobacco industry, investors seem keen to jump ship, with shares falling more than 30% in the past year. This downward trend has continued so far this month, with the stock price tumbling to its lowest point since 2010 following a strategy update from the management team.
As a result of all this, the dividend yield now stands at just over 10%. But is this reaction justified? Or are investors secretly looking for a terrific buying opportunity?
The future of tobacco looks bleak
For years, regulations surrounding cigarettes have been getting stricter. With more research revealing the negative long-term health impacts of these products, pressure against the likes of British American Tobacco has been rising. And following the reveal of a ‘smoke-free generation’ policy by the UK government, management appears to have come to the conclusion that the traditional tobacco market has no long-term future anymore.
As such, the company has re-evaluated some of its brands, most notably the ones it acquired through its £40bn acquisition of Reynolds in 2017, such as Pall Mall, Camel, and Newport. The end result is a planned £25bn write-down, whipping out around 16% of the firm’s total assets.
Needless to say, this isn’t an encouraging sign for shareholders. The write-down itself isn’t too problematic in regards to dividends. After all, impairment charges don’t affect cash flow or the affordability of dividends. But it’s a clear signal that management has lost faith in the future of its core product portfolio.
So is this the end of the road for British American Tobacco? Not necessarily.
What’s next?
The company hasn’t been blind to the threat of regulation and consumption shifts over the last decade. Management has been rigorously investing in alternative, non-combustible products that can satisfy customers without causing severe health problems.
Examples include vapour-based products, oral pouches, and various heated tobacco products. The progress made so far, in my opinion, has been quite encouraging.
Its New Category division is on track to break even two years ahead of schedule. And by 2035, 50% of the group’s revenue stream is expected to derive from its non-combustible products. For reference, the sales contribution stands at around 12% today.
With this business accelerating its internal investments to transition the product portfolio away from traditional tobacco, the recent sell-off in the share price might be a bit overinflated.
Time to buy?
Typically, seeing a double-digit dividend yield is a clear sign of unsustainability. But in the case of British American Tobacco, that doesn’t appear to be the case. The company is still generating lots of cash flow from its existing product portfolio, which is more than enough to cover its dividend payments.
However, that doesn’t necessarily make it a great investment. After all, even if dividends are maintained, a continually declining share price will offset any gains.
This downward trajectory appears to be largely fuelled by uncertainty. And, in my opinion, caution may be warranted. The company is venturing into new territory whose long-term health impacts are still being investigated by scientists.
Therefore, personally, I’m keeping this business on my watchlist until the smoke clears.
