The British American Tobacco [LON:BATS] share price has comprehensively outperformed the FTSE100 index over the past year. While the index is down 3%, the tobacco firm’s shares have soared 30% higher as investors have sought relative security in its defensive business model.
Indeed, demand for tobacco-related products has historically been relatively unaffected by economic slowdowns. This means that the firm’s shares could remain in high demand over the coming months, since the UK economy is already in recession according to the Bank of England and the world economy’s growth rate is expected to almost halve this year.
Furthermore, the company has strong pricing power during a period of high inflation. Cigarettes are relatively price inelastic, which means that demand for them changes only modestly following price rises. With high inflation widely expected to remain in place over the coming months, the ability of firms to raise prices and maintain margins may continue to be of great importance to investors. This may further buoy the stock’s future performance vis-à-vis the FTSE100.
A changing business
British American Tobacco’s shares could be further catalysed by its improving financial prospects. As per many industry incumbents, it is seeking to pivot towards new category products such as heated tobacco and e-cigarettes that are less harmful than cigarettes. It is making strong progress in this journey, especially compared to sector peer Imperial Brands, with new categories revenue growing by 45% in the first half of the year.
It now accounts for 14.6% of the firm’s revenue, which is a 2.2 percentage point rise versus the first half of the previous year. It is likely to become an increasingly important part of its business as further innovation leads to the release of a wider range of products over the coming months. By 2025, British American Tobacco expects to generate GBP5bn in revenue from new category products. This equates to around 20% of its present annual sales.
Although new category products could be subject to changing tax and regulatory rules in future, they offer a more sustainable growth opportunity than cigarettes. And with combustible tobacco products providing strong cash flow in the meantime, the firm has sufficient capital to further innovate and invest in new product areas.
Despite its FTSE 100-beating return over the past year, British American Tobacco’s share price continues to offer a wide margin of safety. It trades on a forward price-to-earnings ratio of 9.2, which suggests there is rating expansion potential – especially in an era of high inflation and slow economic growth.
For many investors, the stock’s appeal lies in its income prospects. It currently yields 6.6%, while a policy of having a 65% payout ratio suggests its dividend is well covered and leaves the firm with sufficient capital to invest in new category growth. Alongside its low valuation, defensive credentials, pricing power and clear path to long-term growth, this suggests the stock will continue to outperform the FTSE100 over the coming years.