There are some very good reasons to think that British American Tobacco (BTI -0.33%) could set you up with a lifetime of income. And given that the yield is a huge 7.9%, at a time when the S&P 500 index is only yielding around 1.2%, there's a very real reason for dividend investors to take the time to examine the stock. The question you need to ask as you do that is this: Is the risk of owning British American Tobacco worth taking on?
What does British American Tobacco do?
British American Tobacco is a European company and only reports semiannually, so investors have to make due with hard financial data for just six months of the year. But that's plenty to show some important facts. For example, the company's combustibles division makes up roughly 80% of revenue. And within that division, cigarettes account for nearly 98% of the company's volume. This is a cigarette company.
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To be fair, 20% or so of revenue does come from other products, this list of which includes things like vapes and nicotine pouches. These fall into British American Tobacco's new categories division, and it is a sizable business. Its efforts to grow this business show that management is actively looking to broaden its reach beyond its core cigarette operation. This is not just good, it is vital to the company's future.
British American Tobacco's cigarette problem
Cigarette customers tend to be quite loyal, buying smokes in both good markets and bad ones. It is why tobacco stocks are placed in the consumer staples sector. Nicotine being addictive helps on this front, of course, but even that fact hasn't been enough to stop the slow and steady decline in volume.
In the first half of 2024 British American Tobacco sold 6.8% fewer cigarettes than it did in the same period of 2023. For the full year 2023 cigarette volumes were off by 5.3%, with the 2022 decline coming in at 5.1%. The downtrend goes back further, but that's enough data to give you an idea of what's going on in this company's most important business.
Like other tobacco companies, British American Tobacco has been raising prices to offset the volume declines. So far this approach has worked, allowing the company to continue supporting its lofty dividend and even providing the capacity for dividend increases. But volume declines and price increases can only go on for so long before a tipping point is reached and the price increases make the volume problem worse. Which is why it is so important that British American Tobacco finds other growth vehicles to offset the declines in the cigarette operation.
As noted, the new categories business makes up around 20% of revenue. That shows progress. But only one of the businesses in that division actually grew in the first half of 2024 and overall revenue ended up falling 1% year over year. Even when adjusting for currency fluctuations, revenue in the group was up just 2.3%. Simply put, that's not enough growth to offset the ongoing weakness in the cigarette operation.
Can British American Tobacco set you up for life?
This is the crux of the problem. British American Tobacco's lofty yield looks like it could set an income investor up with a huge passive income stream. But that's only valuable if it can be maintained over the long term, which is far from clear given the trends in the business that backs the huge dividend yield. Unless you believe strongly that British American Tobacco can find a replacement for its large and declining cigarette business, you shouldn't buy it. If it fails to find a replacement, that dividend may not last for long. Thus, that high yield could, in fact, be setting you up for failure if you aren't careful.
