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Should I buy or sell British American Tobacco (BATS) shares right now?

by | Last updated 26 Nov, 2022 | Consumer Staples

Despite all the volatility in the stock market this year, British American Tobacco Plc (LSE:BATS) shares have proven to be quite resilient. In fact, the stock price is up nearly 30% over the last 12 months.

Can the company’s future performance continue to outshine the FTSE 100 index? And if so, should I be considering the tobacco enterprise for my own long-term portfolio? Let’s explore.

What does British American Tobacco do?

The company is one of the world’s leading consumer staple businesses, offering a wide range of tobacco-based and related products. Its brands are sold worldwide and include popular names such as Dunhill, Kent, Lucky Strike, and Pall Mall, amongst others.

Today, British American Tobacco has over 55,000 employees working across the globe. The firm is partnered with over 90,000 farming partners supplying its factories with its key product ingredient – tobacco.

In recent years, management has been driving investments into healthier alternative nicotine products. Given the amount of social, governmental, and regulatory pressure on tobacco products, this is undoubtedly a prudent move.

The business has invested over £1bn in its New Categories so far. And while it remains a young part of the revenue stream, the growth is proving spectacular, with a 45% surge in the first six months of 2022. Perhaps this is why BATS shares have outperformed the stock market lately.

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What’s BATS’ financial position?

It’s encouraging to see the company adjust its product strategy as consumer opinion surrounding tobacco slowly evolves. And it’s a trend that British American Tobacco seems to be already capitalising on. In fact, the group intends to have over 50 million consumers of its non-combustible products by 2030.

Is this an achievable goal? While it’s certainly ambitious, it’s not an absurd target. Looking at the latest investor presentation for its 2022 interim results, the group announced they already have 20.4 million consumers enjoying these new lines of products.

That’s considerably more than the 8 million reported in December 2018. On an annualised basis, that’s a whopping compounding growth rate of 30%!

Is this “boring” large-cap income stock destined to become a growth stock in the future?

Total revenue for the first half of the year increased by 3.7%, driven primarily by its new non-combustible product lines. So, I’m not sure I’d call this a growth stock right now. But that could change in the future.

Something else worth pointing out is the state of margins. Despite the cost-of-living crisis placing enormous pressure on consumer spending, the firm has successfully been raising prices resulting in a 50 basis point increase in operating profit margin, which now stands at 43.9%.

Needless to say, this is all good news for earnings and the future performance of BATS shares.

What happened to BATS shares?

At the current share price of 3,281p, BATS shares have a market capitalisation of £73.7bn. That actually makes it one of the most valuable companies on the London Stock Exchange.

Yet, in the past, the business was worth considerably more. Back in 2017, the company executed one of the largest tobacco acquisitions in history with the £41.8bn buyout of Reynolds American Inc. The deal certainly helped offset the increased pressure from steadily declining tobacco sales.

Unfortunately, it also opened the door to a new threat that sent BATS shares plummeting, even before the pandemic reared its ugly head.

In 2018 new rules outlined by the FDA in the United States sought to limit the amount of nicotine in cigarettes further as well as introduce new limitations on e-cigarettes and flavoured cigarettes. And following the recent acquisition of Reynolds American exposed a large portion of the group’s production to these new rules.

That took out a considerable chunk of investor confidence and perfectly demonstrates the risk this business faces from regulatory pressure – a risk that continues to be a threat today.

While its new non-combustible products are considered “healthier”, they are still subject to the same strict regulatory standards. And should further limitations come into effect, its goal of hitting 50 million consumers could become even more challenging. Not to mention its main competitors, like Philip Morris International and Imperial Brands, are also starting to venture into this space.

In the long term, can BATS shares return to their former glory? I think it’s certainly within the realm of possibility. But there remains a long road ahead.

What’s next?

The coming months bring lots of excitement for the company from an innovation point of view. At least, that’s what I think.

British American Tobacco is launching some new products, including a new consumable range which is already gaining growth momentum. In addition, the tobacco manufacturer is readily investing in building its international leadership position in Vapour by expanding its portfolio.

While the company is exposed to increasing macroeconomic pressures, which the conflict in Ukraine has exacerbated, its recent financial performance seems to demonstrate resilience to these external factors.

That’s why I’m cautiously optimistic that BATS shares are well-positioned to survive the current turbulent economic environment through its strong brands, operational agility, and solid cash flow generation.

Should I buy or sell BATS shares today?

British American Tobacco is still moving slowly. But there is evidence of the group picking up steam. Its acquisition of Reynolds American might have created several headaches. But it also established a strong presence in the US markets to leverage with new products.

Management aims to generate £40bn in free cash flow before dividends over the next five years. That certainly sounds encouraging to me. And despite investing billions into new product development, there is sufficient remaining cash flow to easily cover its impressive 6.6% dividend yield today.

So, it’s hardly surprising to see that the business has increased dividend payouts annually for more than 22 consecutive years.

That’s why, despite the looming risks, I believe BATS shares could be an excellent long-term addition to my portfolio today.

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Saima Naveed does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and, therefore, may differ from the opinions of analysts in The Money Cog Premium services.

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