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Is this the end for British American Tobacco plc and Imperial Brands plc?

There’s no doubt that at least over the last 10 years, the UK government has been on a strong drive against smoking. By increasing taxes on tobacco, making it illegal to smoke indoors on public premises, and banning the displaying of cigarettes in shops, the government has made its views very clear.

And if those measures weren’t enough, the UK government went one step further last week by implementing new ‘plain packaging’ rules. These rules mean that from now on, all cigarettes to be sold in the UK will have to be packaged in standardised, dull, ugly packaging with health warnings covering a huge 65% of the pack.

Together, these strategies are expected to reduce the prevalence of smoking, and consequently reduce the burden of disease caused by tobacco.

Clearly, there are likely to be long-term ramifications for smoking rates here in the UK and from an investment perspective, investors will be wondering about the impact these rules could have on prominent UK tobacco stocks.

Income favourites
Tobacco stocks British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB) have long been favourites for UK investors. Just look at legendary fund manager Neil Woodford’s portfolio and you’ll find both of these stocks in his top five holdings.

With their resilient earnings and ability to generate and distribute cash, there’s no doubt that both of these companies have rewarded shareholders over the long term.

If you’d bought shares in British American Tobacco five years ago, you would have enjoyed total annualised returns of a healthy 12.9% per year in this time. And Imperial Brands’ shareholders would have done even better, seeing annualised total returns of a fantastic 15.8%.

Given that tobacco stocks are generally seen as stable, boring portfolio holdings, these returns are certainly impressive. But are the glory days over?

While the new plain packaging rules may reduce smoking rates here in the UK, don’t forget that both British American Tobacco and Imperial Brands are truly global companies. For example, British American Tobacco sells its brands such as Dunhill, Kent and Lucky Strike in over 55 countries.

And while revenues at the tobacco giant fell 6.2% last year, the company still managed to increase its earnings per share by 10.1% and lifted its dividend by 4% to 154p per share, putting the current dividend yield at around 3.7%.

Similarly, Imperial Brands’ revenues fell in 2015, but the company’s earnings rose by 8.2% and the dividend was boosted by 10.1% to 141p, a yield of 3.9%.

Long-term sustainability doubts
While at first glance these earnings and dividend increases look positive, personally I’d be approaching the tobacco companies with an air of caution right now.

Dividend coverage ratios for British American Tobacco and Imperial Brands stand at 1.5 and 1.26, respectively, levels that indicate their dividends might be at risk going forward.

And with British American Tobacco saying that trading conditions are “challenging“, and the strong possibility of more government intervention both here in the UK and worldwide going forward, it’s definitely worth thinking about the long-term sustainability of tobacco company revenues before buying shares in this sector.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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