Shares in FTSE 100 dividend stalwart British American Tobacco (LSE: BATS) have cratered over the past 12 months. Excluding dividends, since November 2017, the stock has lost nearly 50% of its value.
Including distributions to investors, British American has produced a return of -42%, underperforming the FTSE 100 by 40%.
Today, I’m going to look at the reasons behind this decline and explain why I think now is the time to be greedy while other investors are fearful.
The perfect storm
Until 2018, British American was considered to be one of the most defensive and reliable income investments in the FTSE 100. But this year, the company has been hit by what I can only call a perfect storm of events.
The company spent 2017 showing off its new range of so-called reduced risk products to investors. These devices, such as e-cigarettes and heat-not-burn cigarette products would, according to management, generate billions of dollars of additional sales and guarantee the firm’s future for many years to come.
This story started to unravel in 2018 when one of the company’s competitors announced worse than expected sales growth of reduced risk products in Japan, a key market. Following this development, investors, and analysts have begun to question whether these devices will be the golden goose tobacco companies seem to believe they are.
The next hammer blow to the firm came a few weeks ago when the US Food and Drug Administration (FDA) announced that it is planning to bring in a ban on menthol cigarettes.
Sales of menthol cigarettes in the US account for around 25% of British Amercian’s bottom line. Losing this considerable market will not only mean a drop in profits but also could force management to cut the highly coveted dividend.
Not the end of the world
Cigarette sales have been sliding for decades, and we have known that, sooner or later, tobacco companies will have to face the music. Developments this year seem to have shocked investors into thinking that the end might be closer than they initially believed.
However, I think the selling is overdone. Before it can bring in a full ban on menthol cigarettes, the FDA has to prove that they are substantially worse than the non-menthol versions. Big Tobacco plans to fight this in the courts, which could take many years to move through the US legal system. And even if a ban does come into place, the addictive nature of tobacco means smokers are unlikely to quit overnight. It is more than likely that they will switch to the non-menthol variant first.
At the same time, reduced risk product sales are still expanding, they’re just not expanding as fast as analysts have been predicting.
Dividend support
Considering the above, I think British American will remain a FTSE 100 income champion for many years to come. The payout is well covered by earnings per share (1.5x) and analysts are expecting earnings to increase by 20% over the next two years. There’s no denying that cigarette sales are in terminal decline, but this has been the case for several decades now, and British American has always come out on top. Right now the shares yield 7.2% and trade at a forward P/E of only 8.7, which I believe offers fair compensation for the risks of investing in the sector.
