Investors are increasingly worried about the risks facing the cigarette industry  

Shares in British American Tobacco (BATS) have fallen by a third in value over the past 12 months as the market prices in the risks of tougher regulation, higher taxes and declining industry volumes.

British American Tobacco is now investing heavily in next generation products (NGPs) in the hope they will support future earnings and cash flow.

Investors will need to decide whether the shares fully discount all the bad news and are now oversold, or whether the risks are still too high to buy now.

Cigarette sales are in decline as people increasingly curb the deadly habit in favour of less harmful e-cigarettes and gadgets that heat tobacco without burning it.

Furthermore, British American Tobacco’s £41.8bn takeover of Reynolds American last year increased its US exposure just as the US Food and Drug Administration announced plans to lower nicotine levels in cigarettes to non-addictive levels.

In its first half trading update (12 Jun), the £84.7bn cap highlighted strong revenue growth from its strategic brand portfolio, including Dunhill, Lucky Strike and Pall Mall.

However, it also cautioned that sales and profit growth would be skewed to the second half of the year – thus raising the risk of a profit warning if it doesn’t achieve this second-half uplift.

British American Tobacco expects global industry volume to be down around 3.5% in 2018 as smoking rates fall, although it is confident in winning market share.

Less harmful cigarette alternatives are increasingly important to the big tobacco firms, facing competition from the likes of e-cigarettes play Juul Labs. The good news is the Reynolds American deal turned British American Tobacco into the world’s leading vapour company.

And by the end of 2018, British American Tobacco plans to more than double NGP revenue to ‘substantially more than £1bn’ with a target to hit more than £5bn in 2022. Donald Trump’s tax reform across the pond is freeing up cash to help fund a ramp up in NGP investment spend too.

In Japan, its tobacco heating product glo has a 4.3% national share and is in growth, despite the Tobacco Heating Products category slowing, while its Vype ePen3 vapour offering launches in the UK in the third quarter.

As e-cigarettes’ sophistication has increased, their popularity has surged and big tobacco players such as British American Tobacco are well placed to capitalise given their enormous research, development and marketing spending power.

Consensus estimates for 2018 point to earnings of 298.12p and a 203.01p dividend from British American Tobacco, puffing higher to 323.18p and 216.63p respectively in financial year 2019.

Based on the latter estimates, British American Tobacco swaps hands for 11.3 times forecast earnings and offers a 5.9% prospective dividend yield.

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