Although British American Tobacco (LSE: BATS) (NYSE: BTI.US) is a better investment proposition than Imperial Tobacco (LSE: IMT), in my opinion, BAT shares are unlikely to offer meaningful upside for some time, in my view. So, BAT shareholders may wonder whether it would be a good time to reduce their exposure. Among these investors is Neil Woodford, whose equity income fund holds a stake in both companies.
What’s The Problem?
Don’t get me wrong: BAT is a relatively stable business with strong fundamentals. Its stock, however, is up less than 1% since 10 July, when I argued that it looked undervalued. Imperial Tobacco stock is down 1.5% since. By comparison, the FTSE 100 index is up more than 2% over the period. Why so?
The tobacco industry is a defensive play only for investors who believe that regulatory hurdles and usual rounds of bad publicity surrounding the tobacco industry won ‘t affect equity valuations at this economic juncture. These investors must also believe that the revenues generated by electronic cigarettes will become more important over time as volumes of tobacco cigarettes shrink. On this front, prospects are encouraging, yet the outcome is not clear-cut.
WHO & E-Cigs
Big Tobacco promoted alternative products such as e-cigs when its main source of revenues and income came under pressure a few years ago. Growth prospects for e-cigs are incredibly healthy into 2020, but the debate is open as to whether the e-cigs segment is actually going to be a game-changer. Big Tobacco wants “to lead the e-cigarette category but really, they want it to stay quite small,” Morningstar analyst Phil Gorham recently pointed out. “They want people to stay in their core business,” he added.
I’d share Mr Gorham’s view. Still, it’s unclear what lies ahead. What is known, though, is that the World Health Organization is asking governments to restrict e-cigs advertising as well as indoor use. The regulations outlined in a report published last week “include a ban on e-cigarettes with fruit, candy-like and alcohol-drink flavours until it can be proved they are not attractive to children and adolescents.”
E-cigs have been marketed “in almost 8000 different flavours, and there is concern they will serve as a gateway to nicotine addiction and, ultimately, smoking, particularly for young people,” WHO added. In the summer of 2013, BAT was the first tobacco company to enter the UK’s e-cig market with Vype. It aims to be a market leader in this segment.
Investors may decide to bet on a further round of consolidation in an industry that is already well consolidated, fair enough. Then, the tobacco industry may offer upside in terms of revenue and cost synergies that will offset a slower rate of growth for revenues and earnings. If bullish investors are right, the rally in BAT shares — which have risen by 23% since the low they recorded in February — may continue, but it’s hard to suggest upside of more than 5% to the end of the year.
BAT is unlikely to record a terrific revenue growth trajectory into 2016. Its operating profitability and cash flow profile are reassuring, and its balance sheet is well capitalised, true. Its trailing and forecast net leverage is about 1.5x; its capex to sales ratio is expected to remain constant at about 4%. The shares trade at a forward price to earnings ratio of 17x, and such a valuation is justified based on fundamentals, but upside from this level is limited. Even less appealing are the prospects for Imperial, whose shares have risen in recent months on the back of takeover rumours. In fact, Imperial stock is fully priced and offers more downside than upside right now.
Of course, BAT stock is a yield play, but there are better alternatives at present. Take Glaxo shares, which also offer a terrific dividend yield.
Glaxo should be included in a diversified portfolio, just as our analysts suggest, but it's not the only company that could provide plenty of upside to investors. Our analysts have identified another terrific candidate, whose shares are likely to outperform the market to the end of the year: it also been included in this report, which investigates the "5 Golden Rules For Building A Dividend Portfolio".
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.