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Why I’ve finally lost faith in British American Tobacco shares

British American Tobacco (LSE:BATS) shares are a divisive talking point in the equities space.

On the one hand, proponents of the company will argue that the tobacco giant has extremely strong free cash flows, which allows British American Tobacco to pay investors a juicy dividend of 7%.

The same bulls will also point to the fact that the company is experiencing notable growth in its alternative product categories – e-cigarettes and heat-not-burn – and is still on track to meet full-year expectations of 3-5% growth.

However, this just doesn’t get away from the reality that British American Tobacco’s core product line – combustible cigarettes – is an industry in heavy decline.

US cigarette sales have declined for 18 straight months

Recent data from global research firm Nielsen showed that cigarette sales in the US were down 11.2% in May, representing a month-on-month decline for 18 consecutive months. This is highly fundamental for British American Tobacco, not least because the firm derives approximately 40% of its global revenues in the US market alone.

In order to counter the threats of a declining cigarette market, British American Tobacco is looking to spear-head its diversification strategy into its new category products, subsequently setting a £5 billion revenue target by 2023. Although the tobacco firm expects to see annual growth of 30% to 50% in its vaping and heated tobacco segments, its current foot-hold is significantly inferior to its core combustible product range.

However, the vaping sector specifically is still in its infancy, meaning uncertainties still exist as to the type of regulatory framework policy makers will eventually install. 

Regulatory uncertainties on menthol cigarettes

Other threats to the tobacco industry further supports my thinking that investors are losing faith in British American Tobacco’s ability to turn things around. For example, fears of a potential US-wide ban on menthol cigarettes still lies in waiting.

This would leave British American Tobacco heavily exposed should the Food and Drug Association proceed with the restrictions, as menthol cigarette sales account for 25% of the company’s earnings. These woes are further amplified with the European Union’s ban on menthol sales coming into full force in May 2020.

The bottom line?

Those still keeping faith in the long-term prospects of British American Tobacco will likely argue that at its current price at the time of writing of 2,797p, the shares are heavily undervalued. However, it remains to be seen how CEO Jack Bowles will turn the company’s fortunes around. Investors are staring at a market capitalisation that needs to double to get back to the 5,579p all-time high its shares reached just over two years ago.

While I take on board the diversification strategy British American Tobacco is taking with its new category products – which will be fully supported by its significant free cash flows – exposure in this segment is still minute.

My overarching concern is that the company’s core cigarette business is under immediate threat on a number of fronts. Whether it’s 18 straight months of declining US cigarette sales, or a potential US ban on menthol products, I think that it might finally be time to let British American Tobacco shares go.

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Kane Pepi has no position in any of the shares 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.