British American Tobacco (BAT) share – A clear buy with an 8 percent dividend

The British American Tobacco (BAT) share attracts fans of high dividends like a magnet. The high share price losses in 2018 combined with further increases in payouts drove BAT’s dividend yield to over 8 percent. The currently exceptionally high dividend is typical of tobacco stocks, the prices of which have come under massive pressure.

BAT is the largest tobacco company in terms of sales the world and thus the flagship of the tobacco industry. Brands like Lucky Strike are probably also known to you as a non-smoker. In this stock analysis, you can find out whether the supposedly low price of the BAT share, including the high dividend, represents an extraordinary opportunity or whether you burn your fingers on the glowing stick.

BAT share
logo British American Tobacco logo
country United States
Branch tobacco
Isin GB0002875804
Market capitalization € 64.1 billion
Dividend yield 8.2%
Stability dividend 0.99 of max. 1.0
Stability gain 0.98 of max. 1.0

The business model: How BAT earns money

BAT is a London-based manufacturer of cigarettes, tobacco and other nicotine products. BAT covers the entire process chain in classic cigarette production from the purchase of tobacco leaves to distribution to the dealers. BAT works with over one hundred thousand tobacco farmers together and supports them with the necessary “know-how” to guarantee the quality of the important raw material. The cigarettes are then manufactured before they are finally delivered to wholesalers and retailers.

The product portfolio of classic cigarettes and next-generation products (NGP) includes more than 200 different brands. However, 40 percent of sales generated with only five of these brands. The 200 brands also include e-cigarettes, which can potentially be used to attract new customers from the non-smoking group. So far, BAT has been able to compensate for the decline in cigarette volume through price increases. In addition, NGP now makes a significant contribution of 5 percent to Group sales. BAT segment of NGPs does not yet have the market power it has in the classic cigarette market. The NGP convince with very high growth rates:

Growth rate NGP in 2019 (source: BAT)

Growth rate NGP in 2019 (Source: BAT)

Another product category are the so-called “Tobacco Heating Products” (THP). They are similar to e-cigarettes, but contain tobacco. In contrast to conventional cigarettes, however, this is not burned, but only heated. This is intended to release less harmful substances. The NGPs are the hope of the tobacco industry, because the sales volume of classic cigarettes has been falling for decades.

The classic cigarette as a phase-out model

The classic cigarette has given tobacco companies such as BAT a steady, growing income for a long time. But the age of the cigarette is over. For decades, the volume sold has been falling globally with the exception of some regions in Southeast Asia. On the one hand, many smokers turn away from the cigarette for health reasons. On the other hand, some of the customers switch to alternative products such as the e-cigarette or the soft drug marijuana, which is now legalized in some countries.

Decrease in cigarette volume in the US (Source: Statista)

Decrease in cigarette volume in the United States (Source: Statista)

This structural change presents the tobacco industry with the challenge of adapting its product range to the changed consumer behavior. The existing cigarette business must be continued profitably for as long as possible in order to finance the operating costs, the development of new products and the ongoing dividends.

Change harbors both opportunities and risks. With regard to the risks, it is unclear how many smokers are switching to next-generation products (NGP). If the NGPs are not accepted, the tobacco companies will lose sales in the long term. The majority of existing smokers will continue to smoke in this case, but fewer and fewer new customers are coming. The speed of acceptance of the NGPs is also crucial. If sales of classic cigarettes fall faster than sales of new products, this will also lead to a decline in profits.

However, the changeover also offers the opportunity to win new customers. Precisely because products such as e-cigarettes or THP (Tobacco Heating Products) claim to be more health-friendly, they attract customers for whom the consumption of classic cigarettes is too harmful. The switch to NGPs is already in full swing and can be seen from the numbers in the 2019 annual report read off. From 2018 to 2019, sales of the “New Categories” increased by almost 37 percent. In total, just under 5 percent of sales were generated in the past fiscal year through “Products with a future”. Interestingly enough, sales of classic cigarettes also increased by over 4 percent in 2019:

Strong growth in sales of Next Generation Products (source: BAT)

Strong growth in sales of Next Generation Products

The positive trend is due to the half-year figures published on July 31 approved. In a half-year comparison, sales of both classic cigarettes and NGPs rose again. However, sales increases of 0.3 and + 14.7 percent are now significantly lower, which is due to unfavorable exchange rates for cigarettes. On the basis of unchanged exchange rates, 0.3 would have turned into significantly higher 2.2 percent.

Revenue growth at Imperial Brands for the first half of 2020

Revenue growth at Imperial Brands for the first half of 2020

In summary, the growing sales don’t look like a crisis at all. But where does the weak share price performance come from? I suspect that many investors are skeptical whether the switch to successors to the cigarette will succeed in general. Because, as you will see shortly, BAT runs a highly profitable business.

BAT is so profitable

BAT generates the highest turnover in the tobacco industry and works very profitably with operating margins of currently 41 percent, whereby the margins have even increased in recent years. In parallel to the margins, sales also increased over time.

British American Tobacco sales and operating margin development

British American Tobacco sales and operating margin development

There were essentially three factors responsible for this.

Buying Reynolds American

The top graph shows the strong increase in sales in 2017 and 2018. The reason is the takeover of the American tobacco company Reynolds American Inc, which was completed in mid-2017. BAT for the year of purchase was only assigned to sales for the second half of the year. Full sales have been consolidated since 2018, which explains the renewed increase in sales this year. The acquisition was important for BAT in order to achieve higher margins through synergy effects. The annual cost of several hundred million (page 10) are noticeable in the stock finder on the increased operating margins, which rose from 35 to 41 percent in the course of the takeover. The analysts expect even higher operating margins of almost 45 percent in the next few years.

Price increases against the decline in sales

BAT counteracts the falling cigarette sales with price increases. Fewer and fewer cigarettes are being sold. If the cigarettes sold become more expensive, however, sales declines can be avoided. Here is a statement from BAT for the 2018 financial year:

British American Tobacco statement Source: Company report (page 6)

Statement by British American Tobacco (source: company report, page 6)

In fact, BAT has been increasing the prices of its cigarettes for years. In 2019, the number of cigarettes sold dropped by 4.7 percent. However, sales from cigarette sales rose by 4.2 percent. The price increases not only compensated for the decline, but even increased sales. However, the strategy is not particularly promising. I personally am skeptical that consumers can endure the price increases forever even in the event of a dependency.

What comes after the cigarette?

“Next Generation Products” (NGP), especially e-cigarettes and “tobacco heating products“(THP) are far from having reached the sales figures for cigarettes, but impress with high growth rates. Last year, NGP sales increased by almost 37 percent, and their total sales in 2019 were already over £ 1.2 billion (GBP), just under 5 percent of total sales and approximately 5.5 percent of cigarette sales. According to the latest figures for the first half of 2020, the share of sales of NGPs rose significantly to 10 percent. With such growth rates, the NGPs are rightly seen as hope for the entire tobacco industry. If the NGPs ignite, the declining cigarette volume can be absorbed and BAT is no longer dependent on the strategy of price increases.

Sales growth of e-cigarettes and THP (data source: BAT)

Sales growth of e-cigarettes and THP (data source: BAT)

Is the dividend of the BAT share safe?

Until 2018, BAT paid the dividend every six months. The distribution has been quarterly since 2018. In the past 12 months, shareholders received EUR 2.27, which corresponds to a dividend yield of 7.6 percent. This means that the return is significantly above the average of previous years. In the dividend turbo of the stock finder, you can see that BAT’s dividend yield ranged between 3 and 5 percent between 2009 and 2018. Since 2018, the return has risen sharply primarily due to the falling share price. Since the dividend yield moves inversely to the price, it increases when the price of the share falls.

Historical dividend yield from British American Tobacco

Historical dividend yield from British American Tobacco

Fortunately, the payout ratio has hardly changed during this period and is almost 70 percent based on free cash flow. This may sound high at first, but it is normal for the tobacco industry. So the dividend doesn’t seem to be in immediate danger. In addition, the dividend has been increasing continuously for 21 years. Despite rising profits and dividends, the stock does not cost more today than it did in the spring of 2011, when shareholders were still satisfied with a dividend of £ 1.19. Today you get £ 2.07.

Course of British American Tobacco

Course of British American Tobacco

Is high debt a problem?

The Reynolds acquisition made strategic sense for BAT. But it also cost a lot of money. This has increased debt from £ 31 billion to £ 80 billion.

British American Tobacco debt development

British American Tobacco debt development

More debt means a higher interest burden. Before the acquisition in 2016, interest expense was £ 681 million. Last year it was almost three times more, at £ 1.8 billion. That may sound dramatic, but it is not. Because in parallel to the interest expense, the operating profit also increased. This was £ 4.6 billion in 2016 and has risen to £ 9 billion by 2019. The share of operating profit that is used for interest has increased only moderately from 15 to 20 percent. Nevertheless, 20 percent is a not negligible proportion. Management has announced accordinglyto reduce the debts piece by piece and can even point to first successes. The total debt has been reduced from a peak of GBP 80.6 billion to the current figure of EUR 76.8 billion.

How does the BAT share compare to the competition?

BAT belongs to the group of the five largest tobacco companies in the world, known as “Big Tobacco” referred to as.

Big tobacco in the stock finder

Big tobacco in the stock finder

The BAT share performs well compared to the competition from the “Big Tobacco Gang” and with a dividend yield of just over 8 percent is on par with Altria and Japan Tobacco in the middle.

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Imperial Brands’ exceptionally high dividend yield doesn’t last long because their dividend is cut by 33 percent. The stock finder calculates the dividend yield based on the cumulative payments of the past 12 months, making it higher for Imperial Brands than in the near future. However, it is easy to see the dividend reduction on the basis of further key figures such as the estimated dividend growth and graphically:

Imperial brands including dividend reduction in the dividend turbo

Imperial brands including dividend reduction in the dividend turbo

Is the BAT share valued favorably?

The BAT share is currently trading at a P / E ratio of 11 and is therefore valued very cheaply, because in the past the share was traded with significantly higher P / E ratios from 20 to 20 at times. Other multiples, such as KCV (price / cash flow ratio) and the historical dividend yield indicate a significant undervaluation. For the determination of the multiples for the calculation of the fair values, I refer to a relatively short period from 2017, since this period reflects the new BAT after the Reynolds takeover. The dynamic stock valuation The stock finder calculates the fair values ​​from this information and displays them graphically:

British American Tobacco in Dynamic Stock Valuation

British American Tobacco in Dynamic Stock Valuation

As a result of the massive price losses from over £ 55 to temporarily under £ 25, the BAT share appears to be significantly undervalued today. Incidentally, the share was significantly overvalued by mid-2017. A striking overvaluation was followed by an equally striking undervaluation.

As a solid dividend payer, the fair value of dividends, in addition to the fair values ​​based on recognized profit, adjusted profit and operating cash flow, seems to me to be a suitable valuation indicator. The leaps in the fair value of dividends (blue line) in the past are due to the change in the dividend rhythm. The fair value dividend is £ 38 per share, 40 percent higher than the current price of £ 27. In the following table you can see how the BAT share is doing against the other tobacco companies in terms of fair value dividends.

Reviews of Big Tobacco companies

Reviews of Big Tobacco companies

The percentage value indicates the ratio of price and fair value dividend from the stock finder. Under the 100 percent mark, a stock is undervalued. The difference to the 100 percent indicates the extent of the undervaluation. The BAT share is 29 percent undervalued. At its fair value, the share has a price potential of 40 percent. In the table you can see that the other tobacco companies also appear undervalued. If you consider that BAT not only convinces with a high dividend but also a successful takeover including high margins, BAT shares are a good choice in the tobacco industry in my opinion. Especially since the analysts forecast a profit growth for BAT despite the pandemic, which will be reflected in the rising fair values ​​of the coming years.

Conclusion: BAT share – a clear purchase with an 8 percent dividend

Like the entire tobacco industry, the BAT share has had to cease in recent years. The fear of the negative consequences of the cigarette as a phase-out model caused a real sell-out. In my opinion, Mister Markt has once again streaked, because price increases have so far been able to compensate for the falling cigarette sales without any problems. BAT also has the NGPs in its portfolio, whose sales volume is strongly increasing. So far, any concerns that the corona pandemic will move smokers to quit have not been confirmed.

The fundamental strength of BAT, including high profitability and further growth potential, makes BAT shares an attractive purchase. That’s why I took the opportunity to buy the BAT share in my private account. Until Mister Market calms down and recognizes the fair value of the share, I, as a shareholder, will be paid with a handsome dividend for the wait.

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