Three Reasons I’d Sell British American Tobacco plc Today

British American Tobacco plc (LON:BATS) is a cash cow that’s on life support, says Roland Head.

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At the risk of alienating readers who remain fans of income favourite British American Tobacco (LSE: BATS) (NYSE: BTI.US), I would like to issue a warning today, explaining why I think that, like many of its customers, British American Tobacco is not as healthy as it appears to be, and deserves a sell rating.

Falling volumes

The first thing to understand about the tobacco industry is that it is in decline. Despite strong growth powered by the insertion of western premium tobacco brands into emerging markets, BAT’s ‘stick volumes’ have fallen by 12% over the last 10 years, from 792bn in 2003 to just 694bn in 2012.

Admittedly, that’s still a lot of cigarettes — but how many other companies manage to convince shareholders that a 12% reduction in sales over 10 years is good news?

Life support machine

BAT has kept shareholders happy with a trio of rising metrics — earnings per share, operating margin and dividend per share — which form a life support machine for the firm’s share price.

BAT’s ample free cash flow is used for two main purposes, share buybacks (2012: £1.3bn) and dividends (2012: £2.5bn). A decreasing number of shares mean that it’s easier to generate increased earnings per share, even on lower sales, and also helps keep the dividend bill under control.

Dividends and buybacks totalled £3.8bn last year, but BAT’s post-tax profits were only £4.1bn. Eventually, I expect these two numbers to meet, after which the firm’s dividends and buyback programmes will come under pressure.

Analysts’ forecasts for the firm suggest that City insiders may agree with my view. After years of double-digit earnings per share growth, consensus forecasts suggest an increase in EPS of 8.7% in 2013 and just 7.5% in 2014.

Too much debt?

My final concern about BAT — ignoring legislative risks — relates to its net gearing of 153%. BAT’s net finance costs totalled £241m during the first half of this year, accounting for 8.6% of its operating profits, and equating to a net interest rate of around 4.5%, which is almost identical to BAT’s prospective dividend yield.

In my view, the firm should be concentrating on reducing its £10.7bn net debt, while borrowing costs remain low. The firm’s board will be reluctant to do this until it’s forced to — but in my view now is a much better time to sell BAT shares than to buy them.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

> Roland does not own shares in British American Tobacco.

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