Can income stock BATS fill valuation gap?

After a torrid 2018, income stock British American Tobacco showed more signs of improvement today.

The revival of British American Tobacco (LSE:BATS) shares in 2019 picked up pace today as the income play eased investor worries over demand for e-cigarettes and other next generation products.

Having enjoyed an 18% surge in the year-to-date, the blue-chip company's shares rallied another 6% today after a 4.5% rise in earnings per share in interim results was accompanied by a forecast of a "good financial performance" across the year as a whole.

The shares, which we tipped at the start of 2019 as one of six to watch, are now comfortably back above the 3,000p threshold and recovering nicely from a dismal 2018.

Last year's sell-off reflected the threat of US regulation on menthol products, which BATS is particularly exposed to following its multi-billion-dollar acquisition of Reynolds in 2017. 

More generally, investors have worried that BATS' generous dividend record could be under threat if the anticipated growth from new products fails to keep pace with declining cigarette volumes. The company's dividend policy has been to pay at least 65% of adjusted earnings per share, leading to the current yield of around 7%. It hasn't cut the dividend since 1999.

Last year the total dividend increased by 4% to 203p a share, which BATS has distributed in four quarterly payments of 50.75p per share. it continues to generate prodigious amounts of cash, despite the need for heavy investment in new products.

Success in new areas will be key to filling BATS' current valuation gap to other stocks in the European staples sector, with analysts at UBS noting that it trades at a 60% discount. The shares are currently on a 2020 forward earnings multiple of 8.5 times, but with the broker believing the blue-chip company has the potential to be worth up to 4,000p.

UBS said the next generation division was performing in line with rebased expectations, with vaping revenues particularly strong after 58% growth in the first half. 

The next gen portfolio includes BATS' flagship vaping brand Vype and tobacco heating product glo. It also sells modern oral products such as tobacco-free nicotine pouches.

Across 2019, BATS said its new products division was on track for the middle of its guidance range of between 30% and 50% growth in annual revenues. New category revenue of £548 million was 3.9% ahead of consensus and 27% higher in constant currency terms.

Total cigarette volumes, meanwhile, declined by 3.5% to 336 billion sticks, but this was offset by a better-than-expected pricing mix as adjusted revenues grew by 4.1% to £12.2 billion.

An update from the Rothmans and Lucky Strike owner in June raised concerns that BATS was  losing market share in the United States. Today's figures showed a 6% drop in US stick volumes to 36.2 billion, while the US combustible market was estimated to be 5.4% down in the period.