Smoking may be falling out of favour in most western countries, but until recently, tobacco stocks have remained very popular.
The situation worsened this morning, when shares in British American fell after the group's 2017 results were published. Although shareholders will be pleased with a 15% dividend hike, City analysts noted that full-year sales were slightly below market forecasts.
Increased market share
BAT completed the £41.8bn acquisition of US rival Reynolds American Inc in July last year. This massive deal means the firm's figures for the year are hard to compare with those from 2016.
However, the company says that after stripping out the impact of the acquisition and of currency exchange rates, sales rose by 2.9% to £15,173m last year, while adjusted earnings rose by 9.9% to 272.1p.
The dividend was increased by 15.2% to 195.2p per share, beating broker forecasts for a payout of 183.8p per share.
Although the firm's tobacco volumes fell by 2.6% last year, the overall market fell by an estimated 3.5%. So by focusing on core growth brands such as Dunhill and Pall Mall, BAT appears to have gained market share.
Next generation products
The group has been one of the biggest investors in next-generation tobacco products. Together with RAI, it has spent $2.5bn since 2012 on vapour and tobacco heating products such as glo.
These -- plus snuff products -- are becoming an increasingly important part of the business. Next-gen sales totalled £397m in 2017, but are expected to hit £1bn in 2018 and more than £5bn by 2022.
This worries me
It's not yet clear whether these products will be as profitable as traditional tobacco. BAT's operating margin was 31.9% last year, cementing its position as one of the most profitable businesses in the FTSE 100.
This is just as well, because it's also one of the most indebted businesses in the FTSE. Net debt rose by £28.8bn to £45.6bn last year, thanks to the additional borrowings required to complete the Reynolds acquisition.
Historically, BAT's high margins have enabled the group to generate a lot of surplus cash. I expect this to continue, but I do think that the need to reduce net debt could limit potential dividend growth.
I estimate that the group's underlying free cash flow was about £4.5bn last year. This was barely enough to cover interest payments (£1.1bn) and dividends (£3.5bn).
Looking ahead, I estimate that a full year of Reynolds ownership could lift free cash flow to about £6bn in 2018. Based on last year's interest and dividend payments, that only leaves around £1.5bn to repay debt.
Even allowing for some efficiency savings, I think it will take the firm a few years to reduce debt to a more comfortable level. To buy this stock, I'd want to see borrowings reduced to around five times the group's after-tax profit. That would give a net debt figure of £30bn, around £15bn below current levels.
The shares currently trade on a forecast P/E of 14 with a prospective yield of 4.6%. That's not cheap enough for me given the group's debt burden, so I won't be buying.
Roland Head has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.