Has British American Tobacco lost its spark?

British American Tobacco has outperformed the market over twelve months but significantly underperformed Imperial Tobacco, which has been born aloft on takeover stories. The sector, despite its defensive qualities, is currently a bit on the heady side.

I last put pen to paper on British American Tobacco (BATS) seven months ago, when the share price was 3,569p. I was cautious about the prospects for the shares mainly on the basis that cash flow was more dependent on net profits than depreciation and that those net profits were in turn, dependent on sales revenue which had not been growing. Sales revenue was estimated, at that stage, in consensus estimates, to decline by 3% next year. Moreover, it struck me that BATS had a sharp-edged problem with the threat of more regulation in the form of plain packaging. BATS is the leading supplier of branded cigarettes on which much of its market share has been based. The packaging is clearly an important component in brand marketing. To lose that advantage is a bit like asking the company to box with one arm tied behind its back. So the poor outlook for sales revenue was not bright for the BAT operating cash flow, share price and potentially dividend progress.

Furthermore, I noted in May, that there was tremendous overhead resistance to further share price advance above 3,800p. I recall describing the chart resembling a series of peaks like some alpine vista, which constituted a big overhead resistance to the share price progress. That included what looked like the double top of twin peaks – something which technical folk always regard as an ominous warning sign of a share price crash.

Consequently, I was not looking for much upside in the share price at that stage and more concerned with a much bigger potential share price downside, if the technical share price chart runes about twin peaks were correct in accordance with market folk law. The logic of my position was that in purchasing the share at 3,569p, an investor would be skating over thin ice for a comparatively modest capital gain of a potentially modest 6% to 7%  beneath (if you will forgive my mixture of metaphors) the twin peaks of a possible ‘double top’. The odds did not look right.

As it turned out, the British American share price did make it to a new peak of 3,931p last month, implying a capital gain of 10%, assuming that the shares had been bought at 3,569p. It also looks as though there will be an annual dividend of some 156p for the year just about to end, according to market consensus estimates.

Although the share price did get into the oxygen light alpine air of new territory, it was there only very briefly. The share price, having peaked at 3,931p last month, has returned to 3,800p again (last seen) on the back of the African bribe reports, the implications of which are unclear. So despite the share price having visited new price territory very briefly, we are basically still in the same dilemma we were in last May. So where does the share price go from here?   Was the new territory peak – as brief as it was, close to the company’s year end – a sign of more upward progress to come next year? Or does the established resistance continue to tell us something?

Turning to market estimates, the consensus is for an estimated decline in top line sales revenue of 7.6% for this year (to 31st December 2015) and pretty much remaining at that level in 2016. If it is, it points to BATS sales revenue falling on estimation, by more than 15% in three years.

At the bottom line, net profits, which fell 4% to 209p a share last year, are estimated to decline by a further 1% this year to around 207p, but to rise by an estimated forecast 7% next year to 222p. The short to medium term picture appears to be basically one where analysts foresee an ending to the decline in earnings this year and a significant recovery next year. Personally, that strikes me as heroic, given the estimates for sales. However, putting things on that basis, the forecast price to earnings multiples are 18.3 times for this year, and 17 times for the year about to begin. However, BATS is more about dividend growth.

The same consensus estimates forecast a 5.4% increase in the annual dividend this year to 156.2p (giving an estimated annual dividend yield of 4.1%) and a further 5.2% increase next year to an estimated annual dividend payout of 164.3p (giving an estimated annual dividend yield of 4.3%.)

Operating cash flow, which had declined some 16% in 2014, staged a rally in the first half of the current year, rising just under 17%. That mirrored the fall in first half sales to a much improved less than 1% year on year decline. In the first six months the company reported a 51% increase in net income, which is a vital contributor to operating cash flow. Along with operating cash flow improving in the first six months, the company also increased cash resources by tapping the loan market at low rates, raising some further 6oo million cash in Euros and 365 million in sterling.

The share price of BATS has outperformed the FTSE100 Index by nearly 10% over the last year, but in turn, was massively outperformed by Imperial Tobacco, which always looked like more of a takeover target. The tobacco industry continues to be a sector in managed decline mode – a path that it has been on for at least twenty years, albeit outperforming by raising dividend payouts as it goes along. On the basis of its relative underperformance against Imperial Tobacco investors might continue considering the merits of a switch out of Imperial into BATS. However, I am still spooked by the BATS ‘double top’ share price chart.

Meanwhile, the share price seems to be at the top of a year’s trading range of between 3,400p to 3,900p, and heading south. It may be that the share is not yielding enough. At a share price of 3,400p, the estimated historic dividend yield would still be only around 4.6%. Tobacco stocks look a bit overvalued at this stage, in my opinion.