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Heads up: will the FTSE 100’s British American Tobacco be the next defensive stock to rebound?

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Hunting for defensive firms that haven’t rebounded lately is challenging, but I think I’ve found a good candidate in smoking-focused consumer goods firm and Footsie constituent British American Tobacco  (LSE: BATS).

At today’s share price around 3,764p, the stock is down more than 30% from its peak last June and looks like it has been caught up in an investor rotation out of expensive-looking defensive firms and into cheaper-looking cyclicals. But unlike some other defensive firms such as Imperial Brands, DiageoGlaxoSmithKline, National Grid, SSE and Unilever, BATS has yet to participate in the bounce-back of these stocks we’ve seen this year so far. Maybe the firm’s time in the sun will arrive soon.

Big borrowings

However, there could be company-specific issues holding the stock down. For example, last July’s almost £42bn acquisition of US peer Reynolds American pushed the firm’s debt up to eye-popping levels. February’s full-year results revealed borrowings had jumped to £44bn, up from £16bn the year before, which means borrowings now are close to seven times the level of last year’s operating profit. We still need a full year of trading with Reynolds American in the fold to get an accurate picture of how debt relates to profits, but historically the stock market has often been kinder to acquired companies than those that do the acquiring. It will take time before we know how well BATS is integrating Reynolds American and how much the move will shift the dial on profits, meanwhile, the stock market hates uncertainty.

City analysts following the company expect earnings of the enlarged business to lift 5% this year and 8% next year. If those predictions prove accurate, BATS will still be moving in the right direction. Meanwhile, the dividend looks even more attractive than it has for some time. The forward yield runs at 5.8% for 2019 and those forward earnings should cover the payment almost one-and-a-half times. One of the great features of the firm’s business is its steady, predictable and rising cash flow, driven by smokers that return over and over again to repeat purchase. The reliability of cash flow justifies high debt loads for defensive companies and in BATS’ case, keeps the dividend moving up year after year. I don’t think those characteristics have changed following the Reynolds American acquisition.

Emerging next-generation products

In April with the annual general meeting statement, the firm said: “An unprecedented confluence of technology, consumer demand, societal change and public health awareness has created a unique opportunity.” Indeed, the company’s long-term future seems to be all about weening its customers off traditional tobacco products and onto less-harmful, smokeless Next-Generation Products, such as those used for vaping, tobacco heating, oral methods of taking tobacco, and nicotine-packed items like snus and moist snuff. By the end of 2018, the firm hopes to more than double its revenue from Next Generation Products to over £1bn. However, despite such progress, the directors expect combustible products to remain at the core of our business for “many years to come.”

I think British American Tobacco retains its defensive credentials and see the dividend yield as ‘attractive’ and worth collecting while I wait for share-price appreciation from here.

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Kevin Godbold owns shares in SSE. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline and Unilever. The Motley Fool UK has recommended Diageo. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.