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British American Tobacco’s Amazing Cash Flow

british american tobacco / imperial tobaccoLast week’s interim results from Imperial Tobacco Group (LSE: IMT) (NASDAQOTH: ITYBY.US) will have been of interest to those considering an investment in its peer British American Tobacco (LSE: BATS) (NYSE: BTI.NY). The two companies have a similar strategy and, so far, similar trading outcomes.

 Imperial reported underlying revenue up 2%, adjusted earnings per share up 3% and a 10% dividend hike. The firm’s CEO, Alison Cooper, reckoned that Imperial’s growth brands outperformed the market, with underlying volumes up 4 per cent. By cutting costs, Imperial is aiming to redirect funds to build growth momentum, with a focus on strengthening market share. Despite tough market conditions, the firm is on course to meet its targets she said.

Will BATS investors enjoy similarly impressive figures and a positive outlook when the firm releases its interim results on 30 July?

Declining industry volumes

Taking the world as a whole, cigarette consumption seems in long-term decline. Last year, British American Tobacco saw a 2.7% reduction in volumes from its subsidiaries. However, against the background of a shrinking industry, BATS reckons it is winning market share.

 The overall trading result nets out to a flat-looking record of performance on revenue and cash flow:

Year to December 2008 2009 2010 2011 2012 2013
Revenue (£m) 12,122 14,208 14,883 15,399 15,190 15,260
Net cash from operations (£m) 3,539 3,878 4,490 4,566 4,427 4,436
Adjusted earnings per share 129.6p 153.8p 176.7p 195.8p 208.6p 217.4p
Dividend per share 83.7p 99.5p 114.2p 126.5p 134.9p 142.4p

Cash flow looks rock solid and BATS seems to function as something of a cash cow, with tobacco smokers providing a steady stream of repeat business. The cash generated is predicable and BATS uses it to buy back its own shares to juice-up the dividend, which has a good record of growth.

So far, BATS’s market-share gains are keeping cash flow steady. However, it won’t take much for industry volume declines to tip the balance over market-share gains, which could lead to cash flow decline. That could threaten dividend progression.

Rising debt

Consistent cash flow is reassuring when it comes to managing a firm’s debt interest payments. BATS’s net debt stands at about 1.75 times the level of operating profits, which isn’t excessive, but net gearing has been rising:

Year to December 2009 2010 2011 2012 2013
Net gearing 117% 86% 99% 116% 145%

Net debt remains manageable but, if cash flow does begin to slip, it is conceivable the firm could divert cash resources from the dividend to debt reduction. Such a move would inevitably slow down, or even halt, dividend progression.

What now?

I reckon BATS could come up with cheerful interim results on 30 July, though, just as Imperial Tobacco did last week.

At today’s share price of 3,438p BATS’s forward dividend yield is running at about 4.4% for 2015 and you can pick the shares up on a forward P/E multiple of around 15. City analysts following the firm reckon earnings’ growth should come in at about 9% that year, so the valuation doesn’t seem excessive.

A reliable and growing dividend payment is always attractive, but I'm also excited by a share idea for capital gains from one of the Motley Fool's top small-cap investors.

Sometimes growth comes from within when a company reinvents itself and pursues a different line of operations. When that happens, valuations can remain modest, as investors are slow to catch on to the new growth potential.

A strong recovery in profits followed restructuring and the directors predict double-digit margins driving a profits surge in the years to come.

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Kevin doesn't own shares in British American Tobacco or Imperial Tobacco.