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Should I Invest In British American Tobacco Plc Now?

Cigarette manufacturer British American Tobacco (LSE: BATS) (NYSE: BTI.NY) enjoys a 42% equity position in its tobacco peer Reynolds American. That connection comes under the spotlight this week as Reynold American confirms its acquisition of another industry player Lorilland, which could involve some of both companies’ assets going to yet another tobacco firm, London-listed Imperial Tobacco.

Pulling together

British American Tobacco makes its position clear: the firm intends to support the transaction by subscribing for additional shares in Reynolds American, with the aim of maintaining its 42% equity position.

Such consolidation and close working seems vital in what appears to be an industry in structural decline. If one firm is a better fit for a particular market, why should tobacco sellers fight it out? Far better to co-operate and combine for mutual benefit, just as this potential deal suggests is happening in the industry.

Declining sales volumes

Last year British American Tobacco’s sales volumes declined around 2.7% even though the firm reckons it’s winning market share. That’s strong evidence of a slipping industry; yet, overall, BATS trading delivers a flat-looking performance on revenue and cash flow:

Year to December

2009

2010

2011

2012

2013

Revenue (£m)

14,208

14,883

15,399

15,190

15,260

Net cash from operations (£m)

3,878

4,490

4,566

4,427

4,436

Adjusted earnings per share

153.8p

176.7p

195.8p

208.6p

217.4p

Dividend per share

99.5p

114.2p

126.5p

134.9p

142.4p

A steady stream of repeat business from addicted smokers delivers cash flow, which the firm uses to buy back its own shares to drive up earnings-per-share and dividend-per-share figures.

So far, BATS’ 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.

So potential industry supporting deals like this one should help tobacco producers such as BATS to keep the cash taps open by extracting every last puff of revenue from smokers as efficiently as possible.

Valuation

At a share price of 3586p, BATS shares change hands on a forward P/E multiple of just under 16 for 2015. City analysts reckon the firm should see 8% growth in its earnings that year and the dividend will likely yield upwards of 4.4%. Forward earnings will cover the payout about one-and-a-half times based on current predictions.

There’s no doubt that British American Tobacco is operating as something of a cash-cow, managing to drive the dividend payment up year after year. However, I can’t bring myself to invest in a firm with poor revenue prospects no matter how well it manages its cash supply for investor income.

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Kevin does not own shares in British American Tobacco.