Given societal trends and regulatory pressures, investors would be forgiven for thinking that tobacco companies offer little more than very nice income. For the sector as a whole this isn't completely incorrect, but I believe the record of British American Tobacco (LSE: BATS) as both an income and growth share may be being underrated by some investors.
There's no doubt the volume of cigarettes being smoked in developed countries is in decline, but the company has proven adept at actually growing revenue through this period by taking market share, increasing prices and recently, acquiring smaller competitors. Over the past 10 years this has resulted in 4%+ compound annual revenue growth and 10%+ EPS growth.
On top of wringing out more revenue from traditional cigarettes, BATS is also targeting £5bn in annual sales from new heated tobacco and vaping products by 2022. The company estimates it already has the highest global share of next-generation products outside the US and predicts £1bn in annual sales by the end of 2018, so this looks to be an achievable target.
Then there is the recent £41.7bn acquisition of the remaining portion of Reynolds American it didn't already own. This has made the combined business number two by market share in the world's second most profitable market, the US, and the largest listed tobacco group worldwide. This will not only grow revenues by giving BATS exposure to this huge market, but also comes with the bevy of market-leading next-generation tobacco products Reynolds was working on.
While the Reynolds deal has stretched BATS's balance sheet, its dividends remain safely covered by earnings and the company's prodigious cash flow means it has retained investment grade status for its new over-subscribed bond offering in the US. Given these attributes, I think the 3.6% dividend yield and solid growth prospects make its valuation of less than 18 times forward earnings a relative bargain, especially as it has had much higher historic valuations.
Worth taking a punt on?
Another highly profitable company in a highly regulated industry that's stolen a march on competitors through acquisitions is Paddy Power Betfair (LSE: PPB). This recently-combined business is performing very well with Q3 revenue up 8% year-on-year (y/y) in constant currency terms to £440m and underlying EBITDA up 9% to £121m.
This growth was led by the group's strong share of the sports betting market and double-digit growth from its smaller businesses in Australia and the US. Management retained a sunny outlook for the rest of the year and guided for £450m-£465m in full year EBITDA, well ahead of last year's £400m figure.
The proposed regulatory crackdown on fixed betting terminals could mean a hit for the group, but it's in a much better position than rivals to absorb it. In Q3, revenue from betting shops as a whole was only £85m and the outgoing CEO felt confident enough in his company's ability to weather the strom that he came out in favour of a clampdown on the machines and cutting the maximum stake from its current £100 to less than £10.
However, interested investors should be aware that its greater growth potential due to high exposure to fast growing online betting means Paddy Power Betfair is much more highly valued than rivals at 19.8 times forward earnings.
Ian Pierce has no position in any of the shares mentioned. The Motley Fool UK has recommended Paddy Power Betfair. 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.