Why British American Tobacco could be a grossly undervalued stock

Last week’s first half trading update by British American Tobacco (LON:BATS) highlighted the improvements that are being made to its business model.

While there has been a continued decline in cigarette volumes that is expected to continue in the long run, growth in sales of reduced-risk products such as heated tobacco and e-cigarettes is on track to be between 30% and 50% for the full year.

This suggests that while the future for cigarettes is highly challenging, with further volume declines likely, there is a significant growth opportunity among next-generation products.

Furthermore, the company is managing its cigarette volume declines through rising prices. It is on track to post revenue growth in the mid-upper half of its long-term guidance range of 3-5%, while an improved operating margin is expected to further catalyse its profitability in 2019.

A changing business

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Over the last couple of decades, the British American Tobacco share price has been a consistent and resilient performer. It has previously been appealing to income investors who desire a robust income that regularly exceeds inflation by a significant margin. At the same time, growth investors have been attracted to its opportunity to benefit from exposure to the emerging world, as well as favourable population trends for the wider global economy.

Now, though, the business is undergoing a major change that is causing a somewhat volatile transitional period. Although cigarettes continue to offer revenue and profit growth, this is due to price rises. They cannot continue indefinitely, since volumes are expected to decline as consumers become increasingly health conscious and regulations become more prohibitive.

However, next-generation products are gradually replacing cigarettes. While their global market value is currently $18 billion versus $785 billion for tobacco, over the long run there is likely to be continued shift from the latter to the former. With British American Tobacco having increasing exposure to reduced-risk products, and it pursuing a strategy that aims to build global brands in this area, it could be well-placed to benefit from changing consumer tastes.

Investment appeal

Although the shift from cigarettes to reduced-risk products is unlikely to be frictionless, it could present an investment opportunity for long-term investors. Since the company’s shares continue to be unpopular as a result of the ongoing changes within the wider industry, they trade on a P/E ratio of 9.6. Furthermore, they offer a dividend yield of 6.9%, which is likely to grow over the medium term due to the opportunities in next-generation products, as well as the potential for cigarette price rises.

Therefore, while the stock may have lost its status as a relatively consistent, defensive and reliable business to own, its growth potential remains high. If, as expected, sales of next-generation products largely offset cigarette volume declines, the business could enjoy a significant tailwind in the long run. While there is a risk that this may not happen, its valuation suggests that investors may have already priced this in to a large degree.