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Is it finally time to return to the British American Tobacco share price?

Tobacco and smoking products company British American Tobacco (LSE: BATS) was a smouldering success for investors from the turn of the century onwards. The share price seemed to just keep drifting up.

But all that changed in the summer of 2017 when the stock blew one final puff on the uphill climb and then collapsed. It’s down more than 50% since then, and the valuation has derated. After trading at earnings multiples above 20 and a dividend yield close to two when it was in the zone of maximum investor optimism, you can now pick up the shares for a price-to-earnings rating a little over nine and a dividend yield of 7.4% or so.

Did investors get carried away?

I think investors got carried away when the share was rising so much. There was all that talk about bond proxies, which meant that dividends from defensive, cash-generating businesses were higher than the yields from bonds and savings accounts. The implication was that the shares of firms such as BATS were almost as safe as bonds and savings accounts, so why not pile in and grab the yield?

Well, one good reason for not loading up during those last heady years of the upswing was the excessive valuation. It didn’t take much to turn investor sentiment – a few regulatory concerns seemed to do the trick. But I also believe all ‘defensive’ companies tend to see their valuations move in cycles. So this could be a cyclical down-leg in the valuation, and it could have gone too far, just as the up-cycle went too far.

Looking at the trading and financial record of BATS over the past few years, it hasn’t done much wrong. Revenues, profits, operating cash flow, and the dividend have all been rising each year. Although the level of borrowings rocketed in 2017 when the firm acquired Reynolds American. However, the tobacco companies have always carried a large pile of debt, justified by the consistency of incoming cash flow.

Good figures and an optimistic outlook

I’m encouraged by today’s adjusted full-year figures, which treat 2017’s acquisition as if BATS had owned it for the whole year. At constant currency rates, revenue rose 3.5% compared to the year before, diluted earnings per share increased 11.8% and net cash from operations shot up 158%. However, borrowings eased back by just 2.7%, so there’s still a long way to go with debt-reduction. Yet, the directors expressed their confidence in the outlook by pushing up the total dividend for the year by 4%.

Some of the statements in the report give the impression of strong trading, such as “outperformance in combustibles, excellent progress in Tobacco heating Products (THP), improved financial performance across all regions,” and “strong operating cash flow conversion.” However, the company acknowledges investor concern about “the proposed potential regulatory changes in the US.”

 In answer to those worries, the company said in the report it has a long experience of managing regulatory developments, a track record of delivering strong growth while investing for the future and “an established multi-category approach.” Indeed, the outperformance of the stock since the millennium started from a similarly depressed valuation because of concerns about the ongoing viability of the business and wider tobacco sector, which chimes with the situation today.

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Kevin Godbold has no position in any share mentioned The Motley Fool UK has no position in any of the shares mentioned. 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.