What Management Would Prefer You Didn’t Know About British American Tobacco plc


I want to take a brief look at British American Tobacco (LSE: BATS) (NYSE: BTI.US) today. I just want to cover two really basic points.

The first point is that prima facie it is a solid company — worthy of the attention of a prudent investor. The second is just a gentle reminder or warning of what may be around the corner for this tobacco giant.

Fundamentals look good

British American Tobacco (BAT) has a rich history and, as far as many City analysts are concerned, it also has a promising future. For those looking for retirement income, BAT’s dividend yield is sitting at a comfortable 4%. The company also has a healthy earnings per share multiple of 1.92, and a price earnings ratio of 17. No alarm bells so far. In addition, BAT has a beta of just 0.7 — so if you’re a nervous nelly, those cigarettes you’re sucking back on aren’t going to be the only things helping you to stay calm in this volatile market. Essentially, the numbers for this company do add up.

So what’s the drama?

It’s a pain-in-the-behind for quite a few British multinationals, but that little event known as the European Sovereign Debt Crisis has never really been resolved and continues to cause problems. The British economy, however, has improved since the Great Recession. As a result, the pound sterling is significantly more attractive than the euro — so British companies that earn income in Europe are suffering at present. BAT is no exception to that.

Earlier this week BAT reported nine-month revenues had fallen 9.6%. Part of that has been blamed on adverse currency movements. In addition, BAT has also noted in the past that as the euro weakens the group also suffers from asset devaluations, as well as “the loss of commercial opportunities to manufacture and sell tobacco products” in the region. This Fool doesn’t see those problems going away in the short term.

There’s also a basic demand problem, too

In addition to currency concerns, there’s a demand dilemma as well. Volumes have been hurt in a large portion of BAT’s European market (which accounts for around a quarter of the group’s total revenue). Worldwide, the total number of cigarettes sold fell by 1% to 495 billion in the nine-month reporting period.

This isn’t a new phenomenon, either. Last year’s annual report highlighted some of the areas that the company was concerned about. Italy, for example, was described as a “difficult trading environment”. Volumes in Spain as well were reported as declining sharply. Other markets suffering a downturn in demand included Germany, Switzerland and the Netherlands.

Fewer smokers and one Foolish thought

The takeaway is simple — consumers are getting very sensitive about their disposable income. Indeed we already know that it’s providing challenging conditions for companies like Tesco, Diageo and Unilever. And while a company like British American Tobacco may have a more inelastic demand curve than some other brands, we are now starting to see it stretch a bit. Perhaps some of Europe’s smokers are favouring cold turkey over not having any turkey to eat at all!

Market movements

There are already some City analysts that are starting to waver on this investment. Some analysts are even forecasting the price to drop as to as low as 2,600 (22% drop).

What may have changed the minds of some number crunchers in the City is just how long it’s taking for Europe’s economy to heal. BAT has reassured investors that firm pricing and cost-cutting in many of its markets have helped the tobacco company maintain, and even in some cases, improve margins. From a medium-term perspective, however, I think management would prefer you didn’t know that that can’t last forever. At some point Europe will need to show significant signs of economic improvement — otherwise a fair chunk of British American Tobacco’s income will be under threat.

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David Taylor 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.