Here’s why the falling BATS share price makes me want to buy

Two things about the British American Tobacco (LSE: BATS) share chart strike me. One, the BATS share price has fallen 45% over five years. Earnings have been rising over that timescale, but that hasn’t done much for the shares.

The second thing on the chart is a big letter D every three months. It shows dividends, and British American has been handing them out like candy floss at a funfair. At the 2021 interim stage, the company reiterated its “commitment to [a] 65% dividend payout ratio and growth in sterling terms.”

The company paid 215.6p in dividends in 2020. At the current price, that’s a 7.9% yield. Do investors not want that kind of money? I know many will have ethical qualms over investing in tobacco. But surely market forces should offset that pressure?

BATS share price valuation

When I look at valuation. on 2020 earnings, the BATS share price gives me a trailing P/E of only 8.2. As well as not wanting fat dividends, it seems investors don’t want cheap shares either.

The real reason is, I think, nothing to do with ethics. I reckon it’s just the obvious realisation that smoking is becoming increasingly unacceptable across much of the developed world. British American is still seeing annual earnings growth, but it’s slowing. From double-digit percentage rises in EPS just a few years ago, growth was down to just 3% in 2020.

Yet there are two trends that I think will offset the decline and keep BATS shareholders in long-term dividends. One is that growing affluence in the developing world is helping boost consumption of leisure products like tobacco. Increasing wealth is also helping with sales of higher-margin prestige brands.

Vapour clouds

The other trend is the move towards healthier consumption. We’ve all seen those folks with their vaping products, billowing what look like clouds of steam from a passing vintage locomotive. Vapour products are firmly on the up, growing in revenue by 59% in the first half of 2021.

British American is still in a net investment phase in what it calls these New Category products. They’re still losing money, though BATS expects the losses to reduce by the end of the full year. But any loss will surely put pressure on the BATS share price.

The big question is whether traditional smoking products will be enough to maintain earnings growth until New Category products reach significantly higher volumes. I doubt it. And that’s almost the biggest downside for me.

Lean years ahead?

I hate trying to make predictions. But I fear we’ll see that slowing earnings growth turning into earnings falls for a few years, while the company’s transformation matures. If that happens, I reckon we could see the BATS share price slide even lower. And, with the 65% payout ratio, the dividend could decline too. How long would it take to get back to growth? It could be some time.

But I think the current valuation already allows enough safety margin to cover a few less rosy years. And even if the dividend should head a bit lower for a while, I still expect a bumper yield. So why aren’t I buying? It’s the ethical issue that’s the biggest problem for me. At times like these I curse the ethical stance that’s stopping me buying. But I can’t change that stance so British American isn’t for me.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended British American Tobacco. 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.

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