British American Tobacco: Buy, Sell, or Hold?

LONDON -- I'm always searching for shares that can help ordinary investors like you make money from the stock market. Right now, I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index. 

I hope to pinpoint the very best buying opportunities in today's uncertain market, as well as highlight those shares I feel you should hold... and those I feel you should sell.

I'm assessing every share on five different measures. Here's what I'm looking for in each company:

  1. Financial strength: Low levels of debt and other liabilities.
  2. Profitability: Consistent earnings and high profit margins.
  3. Management: Competent executives creating shareholder value.
  4. Long-term prospects: A solid competitive position and respectable growth prospects.
  5. Valuation: An underrated share price.

A look at British American Tobacco
Today, I'm evaluating British American Tobacco  (LSE: BATS  ) (NYSEMKT: BTI  ) , a British multinational tobacco company, which currently trades at 3,482 pence. Here are my thoughts:

1. Financial strength: British American Tobacco is in a solid financial position with net debt of only 1.5 times operating profits and interest cover a hefty 13 times. The company also generates consistent and stable free cash flows averaging over 3 billion pounds per year for the past three years.

2. Profitability: Revenues have increased 7% per year for the past five years while earnings per share has grown by 13% per year and dividends per share by 15% per year for the past decade. Operating margins have expanded from around 10% early in the decade to around 35% the last few years. The 10-year average return on equity (ROE) and return on capital employed (ROCE) have been a remarkable 60% and 35%, respectively.

3. Management: Nicandro Durante assumed the post of CEO in March 2011. He was previously the COO and has been with the company since 1981. British American Tobacco's share buyback program, which was suspended in 2009, was resumed in 2011. It has bought back 750 million pounds' and 1.25 billion pounds' worth of shares in 2011 and 2012, respectively. The board has agreed on repurchasing 1.5 billion pounds' worth of shares for 2013.

4. Long-term prospects: British American Tobacco is the world's second-largest tobacco company by market share, with a portfolio of 200 brands sold in around 180 markets worldwide. The group has significant exposure to emerging markets, where it derives around 70% of its profits.

The group's four well-known brands, which it refers to as the Global Drive Brands (GDBs -- Lucky Strike, Kent, Dunhill, and Pall Mall) accounted for 35% of the group's revenues in 2011, and have performed well the last few years increasing volume and market share. As of the last trading statement, GDBs have increased volume by 3% and market share by 0.3%. However, group volumes declined by 1.6% due to the difficult trading conditions in some of its major markets, particularly Southern Europe. But revenues at constant rates of exchange still grew by 4% and adjusted diluted earnings per share were up by 7%. Also, the group saw increases in underlying market share and an increase of 1.6% in operating margins.

5. Valuation: Shares are trading at a forecast price-to-earnings (P/E) ratio of 15, higher than its 10-year P/E average of 13 and the sector P/E of 11. It also returns a yield of 4%, twice covered.

My verdict on British American Tobacco
British American Tobacco has performed remarkably well the past decade, with consistent above-average growth in revenues, earnings, dividends, and free cash flow; healthy operating margins; and excellent returns on capital. Despite increasing government regulation, excise taxes, and the threat of illicit trade, plus the continuing economic weakness in some of its major markets, I believe the company can continue to perform well this decade with its scale, pricing power, broad portfolio of products, and its significant exposure to developing economies. Although its shares are already quite pricey, I believe the company will continue to increase dividends above the rate of inflation and meet its target of growing earnings in the high-single figures annually over the medium to long term.

So, overall, I believe British American Tobacco at 3,482 pence looks like a buy.

More FTSE opportunities
In addition to British American Tobacco, I am also positive on the FTSE shares highlighted in "8 Dividend Plays Held by Britain's Super Investor." This exclusive report reveals the favorite income stocks owned by Neil Woodford -- the City legend whose High Income fund turned 10,000 pounds into 193,000 pounds during the 25 years to 2012.

The report, which explains the full investing logic behind Woodford's dividend strategy and his preferred blue chips, is free to all private investors. Just click here for your copy. But do hurry, as the report is available for a limited time only.

In the meantime, please stay tuned for my next verdict on a FTSE 100 share.

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