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The BATS share price gives an 8% dividend yield. I’d buy now

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The British American Tobacco (LSE: BATS) share price edged higher this morning after the company said revenue growth this year is likely to be stronger than expected.

BATS share price has fallen by 10% over the last year as the tobacco sector has fallen out of fashion. This has left British American shares with a dividend yield of 7.8%. That makes it one of the highest yielders in the FTSE 100. I reckon the payout looks pretty safe too.

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More people are smoking

Although smoking rates are falling in most developed markets, the total number of smokers globally has been rising. This is due to population growth. A new study published in medical journal The Lancet has found that the number of smokers globally reached 1,140m in 2019, 150m more than in 1990.

About two-thirds of these smokers are located in 10 countries, including China, Indonesia, India, and the US. BATS has exposure to all of the world’s top smoking markets, except China, where tobacco sales are state controlled.

In today’s half-year update, the company said that, so far this year, it’s seeing “continued recovery in Emerging Markets” and “a robust US performance.” The company also said its share of the global cigarette market has risen by 0.1% so far this year.

BATS’ revenue is now expected to rise by at least 5% in 2021, compared to previous forecasts of 3-5%.

BATS share price: I think it’s cheap

Tobacco is a mature business, but I don’t see any signs that the big players are winding down. BATS’ profits have continued to rise slowly and its sales are stable. Cash generation is also strong — a key requirement for reliable dividends.

In 2020, the group generated £7,295m of free cash flow. That’s cash which is surplus to requirements and can be returned to shareholders. This was enough to cover the dividend 1.5 times, giving a comfortable margin of safety.

Despite this, BATS current share price values the stock at just nine times free cash flow. In my view that’s cheap, given the group’s track record of cash generation.

Will the shares rise?

If I’m right and the dividend’s safe, then perhaps BATS’ share price should rise? Even if the shares rose by 25% to 3,600p, this stock would still offer a 6% dividend yield.

I can see the case for a higher share price, but I’m not sure how likely it is. There are two reasons why I’m cautious.

Firstly, much of the company’s earnings growth comes from cost-cutting, share buybacks and price increases. The number of cigarettes being sold globally is falling — British American expects market volumes to decline by 3% this year.

A second risk is that the company still has quite a lot of debt. Although net debt’s falling, this is happening quite slowly. The company still expect a leverage multiple of 3.0x EBITDA at the end of this year — above my normal comfort level.

On balance, I think the BATS share price could climb another 10-20%, but probably not much more. I view this as a pure income stock. And with a well-supported forecast yield of 7.8%, it’s a share I’d be happy to buy.

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Roland Head 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.

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