How Will British American Tobacco Plc Fare In 2014?

Should I invest in British American Tobacco plc (LON: BATS) for 2014 and beyond?

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For most shares in the FTSE 100, 2013 was a good year and investors have likely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses while pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at cigarette manufacturer British American Tobacco (LSE: BATS) (NYSE: BTI.US) .

Track record

With the shares at 3190p, BATS’s market cap. is £60,193 million.

This table summarises the firm’s recent financial record:

Year to December 2008 2009 2010 2011 2012
Revenue (£m) 12,122 14,208 14,883 15,399 15,190
Net cash from operations (£m) 3,539 3,878 4,490 4,566 4,427
Adjusted earnings per share 129.6p 153.8p 176.7p 195.8p 208.6p
Dividend per share 83.7p 99.5p 114.2p 126.5p 134.9p

1) Prospects

In a recent statement, British American Tobacco reported revenue up 3.5% for the first nine months of its financial year to September. However, cigarette volumes are down 3.2%. The business model here seems to rely on raising prices and trying to win a greater share of a declining market.

According to the directors, growth in many markets such as Bangladesh, Pakistan, Vietnam, the Middle East and the Philippines, was more than offset by lower volumes in Brazil, Russia, Turkey, Ukraine, Egypt and Western Europe. Looking at the table above, it’s clear that cash flow has not been growing.

For investors, BATS’ prospects appear to involve the firm scrambling to return as much cash as possible through the dividend. Share buy-backs ensure that the earnings and dividend per share keep rising, a situation that seems set to continue through 2014 and beyond.

2) Risks

Rising charge-out prices seem unlikely to keep revenue increasing indefinitely. Sooner or later, the cash flow is likely to start to slip if tobacco and cigarette sales volumes keep declining. Can an ongoing share buy-back programme keep up? Maybe, but a shrinking business is surely vulnerable to P/E compression. BATS investors could end up weighing dividend gains against capital losses. Will the former overcome the latter? I’m not sure, so investing in BATS now looks risky to me.

3) Valuation

City analysts following the company expected earning per share to grow 6% in 2014. Those earnings cover the forward dividend about 1.5 times, producing a forward dividend yield of about 4.7% at the current share price.

The forward P/E multiple is running at nearly 14, which I think is a bit rich given growth and yield expectations. That further worries me that P/E compression is likely going forward.

What now?

It goes against the grain for me to buy a shrinking business, no matter how well the company might manage cash flow for investor returns. For that reason, I’m not going to buy or watch British American Tobacco in 2014 and beyond.

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.

> Kevin does not own shares in British American Tobacco.

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