Some things in life just do not seem to make sense. For me, the share price of British American Tobacco (LSE: BATS) is one of them. I have been scratching my head wondering if my continued optimism in the firm’s outlook is misguided.
As an investor, it is always important to consider both sides of an investment case. It is too easy simply to ignore negative information. That can be a costly mistake.
The bear case
So what might explain the ongoing fall in the British American Tobacco share price? It dipped 32% last year and is 11% below where it stood five years ago.
A key concern is the long-term decline in demand for its core product, cigarettes. Indeed, the firm rattled the market badly last year when it announced it would take a £25bn write down in the value of key cigarette brands in the expectation that they would eventually be worth zero.
Along the way, there is an ongoing risk of further regulation and litigation affecting profitability. The company’s balance sheet is also debt-heavy. Adjusted net debt stood at £37bn at the half-year point.
One big problem
To summarise the bear case, I see two big concerns. The main one is that the company’s cash cow is in long-term decline and that is unlikely to change.
Yes, it can put up prices to offset declining volumes, but that can only work so far before it leads to further volume decline. After all, competitors may decide to lure the company’s customers by keeping their own prices lower.
Another concern is the debt pile. But I reckon that can actually be seen as part of the first challenge.
After all, if the company can keep generating the sorts of huge cash flows it currently does, then I do not think servicing the debt pile is as big an issue as it may initially seem. A lot of very savvy investors have been willing to let British American borrow large sums from them. I presume they expect to get it back with interest.
Why I’m optimistic
I am definitely not underestimating the significant risk of declining cigarette sales poses to the British American Tobacco share price. After all, the product remains the company’s key profit driver and that is highly unlikely to change in the near future.
But cigarette smoking has been declining in many markets for decades already. Despite that, cigarettes remain a huge and highly profitable market. I think the business could keep going for decades yet.
Meanwhile, non-cigarette forms of tobacco consumption like vaping are growing.
For now lots of small companies are trying to muscle in to this market. But I expect the long-term prize to go to companies that already have strong brands, developed distribution networks and deep experience of navigating the complex regulatory framework.
In other words, I think British American’s most profitable days could be ahead of it, not in the past.
That is not reflected in the double-digit dividend yield, among the highest of any FTSE 100 share, or the price-to-earnings ratio of just 6.
To my mind, British American Tobacco’s share price looks like it may be the FTSE 100’s biggest bargain. I plan to keep holding the shares and would happily buy more if I had spare cash to invest.
The post Is today’s British American Tobacco share price the FTSE 100’s biggest bargain? appeared first on The Motley Fool UK.
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C Ruane has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. 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.
