BAT sticks to its dividend pay-out plan despite mild profit warning

“British American Tobacco’s decision to stick to its plan of a 65% pay-out ratio for its dividend in 2020 means investors won’t be coughing and spluttering too badly after today’s mild profit warning, but they may still feel the need to clear their throat rather nervously after the FTSE 100’s move to trim back sales and earnings per share growth forecasts,” says Russ Mould, AJ Bell Investment Director. “A hit to duty free sales thanks to the sharp drop in international air travel, weak demand in emerging markets where lockdown has hit hard, slower-than-anticipated growth in Next Generation Products (NGPs), as well as ongoing pushback against smoking from public health authorities all mean BAT will now miss its prior sales and profit growth guidance. 

“The company now expects sales growth of 1-3% this year on a current adjusted basis, down from 3-5%, and earnings per share (EPS) to grow at a mid-single digit percentage rate, rather than in the high single digits. EPS growth is still expected to outpace sales growth thanks to CEO Jack Bowles’ cost-cutting and efficiency programmes, market share gains and also strong pricing, which is helping to offset lower than expected volumes.

“And it is EPS growth that income-seekers will be watching with great care, since BAT has a target of paying out 65% of annual EPS by way of dividends. 

“Ahead of today’s statement, analysts were looking for a 4% increase in EPS to 335.4p a share. That underpins estimates of an identical increase in the full-year dividend – which is paid in four quarterly instalments – to just shy of 219p a share. If that sum is indeed paid, it would add to BAT’s streak of increased annual dividend payments which dates back to 1998, according to Refinitiv data.

 
Source: Company accounts, Sharecast, consensus analysts’ forecasts

“Those forecasts will not be going up after today and they may even come down very slightly, but a dividend of just under 219p a share still equates to a dividend yield of 7.3%, more than enough to catch the eye of income-starved investors who have seen 46 FTSE 100 firms cut, defer, suspend or cancel a dividend payment already in 2020.

“It is also enough to make BAT the second-biggest single dividend payer in cash terms in 2020, according to consensus forecasts.

Source: Consensus analysts’ forecasts, Sharecast, Refinitiv data

“The question that analysts need to ask themselves about BAT – and indeed the other big payers in the FTSE 100 – is whether the pay-out ratios are defensible over the short-term, owing to any hit to business from COVID-19, and then the long-term, which issues such as competitive position, regulatory threat, management acumen and financial strength will all remain key considerations.

“A pay-out ratio of 50% - or earnings cover of 2.0 times – is probably ideal as that provides some insurance against any expected development, such as a recession and earnings downturn (or something completely unforecastable, like a pandemic). BAT’s pay-out ratio target of 65% equates to earnings cover of 1.53 times, since earnings cover is simply the obverse of the pay-out ratio.

“Some wiggle room can be granted here to firms that have particularly strong balance sheets or highly predictable cash flows where demand is relatively insensitive to the wider economy – utilities and consumer staples, such as drinks firms, might fall into this category. Tobacco certainly used to come under this bracket too, but falling global volumes and regulatory pressure on branding and advertising and now Next Generation Products may mean that some investors are less convinced of the long-term cash-generative capabilities of tobacco.

“Imperial Brands’ woes have not helped bolster confidence but BAT seems confident for now that it can avoid joining its FTSE 100 peer in cutting its dividend, given that management is sticking to the 65% pay-out ratio plan and still forecasting earnings growth on a constant currency basis for 2020.

 
Source: Company accounts, Sharecast, consensus analysts’ forecasts

“One further way of stress-testing the BAT dividend is to look beyond dividend cover and the pay-out ratio and look at free cash flow cover and do so in conjunction with the balance sheet.

“BAT has piled on debt in the past decade, thanks to acquisitions, notably Reynolds American, and also £4.3 billion of share buybacks during 2011-14. Net liabilities, including pension deficits and leases, has soared from £8.5 billion to £44.3 billion since 2010. A net debt to equity ratio of 66% does not suggest that the balance sheet is unduly stretched although intangible assets of £119 billion compare to net assets of £64 billion, so the foundations are not as strong as they could be.

 
Source: Company accounts

“That made for an annual interest bill of £1.5 billion in 2019, a sum which has to be paid and which consumes cash that could otherwise go on investment in the business or dividends. 

“Free cash flow cover takes into account interest payments, as well as taxes, pension contributions, capital investment and other cash spend, all of which come before shareholders get a look-in. Last year, free cash flow cover for the dividend was 1.3 times, pretty much where it had been in 2010, so shareholders can take some comfort from that, as BAT has thus far coped pretty well with the regulatory pressures that face its industry. Equally, that figure does not give too much downside protection should anything else go wrong and industry volumes contract more quickly than expected over the long term.

Source: Company accounts

“Today’s trading update is unlikely to change the mind of those who believe in the sustainability of the company’s admirable record of dividend growth or those who think the opposite believe that shrinking volumes and regulatory pushback mean that cash flow will eventually start to weaken and expose investors to the danger of a dividend cut.”

 
Source: Company accounts