British American Tobacco: Still a Smoking Hot Investment?

British American Tobacco at 4,006p following the annual results for the year to 31^st December 2015. The share price has broken into new territory and is now towards the ceiling of its share price corridor of upward and downward share price swings around the central trend. The shares look good value in dividend yield terms and fair value in PER terms in relation to the market’s recent valuation of them. They have room to pull back within the trend corridor and would look an attractive buy at that stage. I mark them a hold for above average dividend yield and dividend growth for those who have them already.

When I last looked at British American Tobacco (BATS) I was made nervous by the share price chart pattern, which had taken on the outline of what seemed to me to be big peaks of overhead resistance. The share price then was 3,800p, having at that time recently peaked at 3,980p.

To continue the story, the share price returned to 3,980p when moving above into new share price territory and to a new peak of 4,090p at the beginning of this month. It now looks to be at the top of its trend range, making a swing down within the share price trend corridor look predictable. In short, the share price pattern suggests that the stock has for the time being swung as far upwards as appears logically reasonable. Even if the trend remains in place there is room for the share price to move down after a good run. I add that BATS has performed handsomely in capital gains terms: over the last 12 months the BAT share price has risen 6% whilst the FTSE 100 Index has fallen 10%. This is not surprising for a dividend stock in a market suffocating from bad news from oil and metals.

BAT’s performance last year was clearly impressive, despite latent concerns about plain packaging for a business that is driven by its branded items. As it turns out, BAT did well in 2015 from the performance of its branded cigarettes, particularly its “Lucky Strike” brand. What it calls its ‘key market global brands’ increased sales by 8.5%. That was a good step forward – by a foot with an Achilles heel because it makes the company particularly vulnerable to plain packaging anti-cigarette smoking legislation and regulation, which is something that investors should continue to have in mind.

Last year reported revenue fell 6.2%, but that had much to do with currency movements. Stripping those out, the company estimates that sales revenue would actually have risen by 5.4%. That dramatic difference in outcomes is accounted for by the big impact of emerging economy currencies, which were particularly weak last year. Similarly the reported 7.6% fall in operating profit becomes a 4.0% increase in constant currency terms.

Looking at the volume figures – which enable us to sidestep currency and other financial shenanigans – volume sales were reported down by 0.5% but down 0.8% organically – that is to say before taking into account the benefit to the top line sales figure from acquisitions. The 0.5% decline in volume sales was comparatively very good when you set it against the claimed tobacco industry wide 2.3% decline in volume sales. Basically, volume sales were close to those given for 2014 in Asia Pacific, Western Europe and Eastern Europe and the Middle East but down in the Americas.

The company reasonably invites applause for the fact that its results in 2015 were achieved in a year of unprecedented adverse exchange rate movements and pressures on personal incomes. It is a remarkable fact that in 2015 the company also clocked in with a gross margin figure of nearly 77%, which is on the face of it a tribute to the company’s pricing power. It is also to be noted that its net and operating margins were also a good looking 34.5% and 34.7%. The return on assets employed last year came in at a reported near 16%, with the return on investments at 23%. Thanks in part to massive balance sheet gearing – in 2015 that was a 347% gearing of equity stemming from a 77% gearing of total assets – the reported return on equity was a sky topping 82%.

The key question about 2015 is the one which asks how, in a particularly difficult year and in terms of cash flow, did the company manage to spend almost £4,000 million on capital expenditure and £2,770 million on dividends and still end up with increased cash in the balance sheet when reported operating cash flow was only 70% of that amount. (I add the significant facts that capital expenditure and investment was up massively in 2015 and diluted net income hardly budged year on year.) That of course was achieved by a big increase in debt which rose in relation to the previous year by 6.3 times, hence last year’s mighty jump in gearing.

BAT acquired new tobacco operations last year and that required cash. That is key to outcomes this year because British American Tobacco grows its profits in part out of acquisitions and their financial rationalisation. In 2015 it laid the ground for profit and operating cash flow planning for this year and next, and that looks short-term bullish. Such acquisitions are presumably one of the reasons for the fact that the balance sheet is full of intangibles that swamp tangible assets.

Corporate activities last year seem reflected in analysts’ consensus estimates and forecasts for this year and next. Essentially, we are unlikely to see the disadvantageous currency exchange movements which were such a feature of last year’s results. Indeed, if there were to be any general downward movement in the Sterling exchange rate after a Brexit vote, it would, all other things remaining equal, benefit BATS. Second, we should see the benefits of last year’s acquisitions to profits, operating cash flow and dividends.

The current analyst forecasts for this year and next are as follows. The consensus estimated revenue figure of £14,000 million in 2017 will be, if achieved, the best revenue result since 2013. That should also be seen in the context of the reported revenue figure of £13,104 million last year. It estimated that earnings per share will increase 9% this year to a forecast 228p and next year by an estimated 8% to 247p. At the share price of 4,006p that puts BAT shares on prospective estimated price to earnings ratios of 17.7 times for this year and 16.4 times for next year. At the same time, it is estimated that dividends will rise to a forecast 164.4p for this year and a forecast 173.3p for next year, putting the shares, at 4,006p (last seen) on a prospective estimated dividend yield of 4.1%, rising to 4.3%.

That seems a good dividend income at a reasonable share price in relationship to the current forecast consensus price to earnings ratio of 16.4 times. It is a high price to earnings ratio both generally and in relation to the lower projected earnings growth rate. However, the market is by convention seemingly happy with that PER/dividend yield relationship in the case of British American Tobacco.

As a final note, I still worry about any extension of plain packaging anti-smoking legislation in more territories. Until, then it looks as though BAT will continue with its familiar dividend and cash flow methods.