When most investors take a glance at British American Tobacco's (BTI -1.03%) financials, the first thing they probably notice is the stock's huge 7.3% dividend yield. That yield is far higher than the 1.2% being offered by the average S&P 500 stock today, and it's a huge draw if you are trying to live off the income your portfolio generates. However, investors considering this stock need to factor in that this yield might not be sustainable over the long term if British American Tobacco can't adjust to the changes taking shape in the tobacco and nicotine industry.
What does British American Tobacco do?
As the company's name suggests, British American Tobacco makes tobacco products. To put some numbers on that, revenue from combustible products accounts for around 80% of the company's top line. Cigarettes account for 97% of the volume of the combustible products it sells. So cigarettes make up around 80% of the company's business.
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That's a problem. As peer Altria recently highlighted, since 2019, the number of people only using combustible nicotine products in the United States has fallen from 34 million to 28 million as of the end of 2024. The nicotine category itself has grown thanks to non-combustible products, but cigarettes are clearly facing material headwinds. While that's just the U.S. market, it highlights a broader trend in the cigarette industry.
The problem is illustrated in British American Tobacco's cigarette volumes, which fell 5% in 2024. That follows drops of 5.3% in 2023 and 5.1% in 2022. So this is a long-term trend. Like its peers, British American Tobacco has been offsetting volume declines with price increases. This has allowed it to support and even grow its dividend, despite the weak fundamentals in its most important business.
British American Tobacco is buying time to move beyond cigarettes
None of the cigarette makers are ignorant of the risks they face. British American Tobacco, for its part, is attempting to add products outside of cigarettes. It calls these products "new categories," a group that includes things like vaping products, heated products, and pouches. It has built up a fairly sizable portfolio that accounts for nearly 20% of revenue.
That's good news, as it shows the company is serious about moving beyond cigarettes. But can it make this transition without putting the dividend at risk? That could be a problem. British American Tobacco paid out more in dividends than it earned in 2024, so its dividend payout ratio was above 100%. If you look at adjusted earnings, which takes out costs that the company believes obscure its true earnings power, the payout ratio is a more reasonable 66%. Still, given the direction of the business, that isn't a huge comfort.
NYSE: BTI
Key Data Points
The payout ratio is probably a warning sign. To be fair, dividends aren't paid out of earnings. They're paid out of cash flow. The dividend only ate up around two-thirds of the company's cash flow in 2024. That's in line with the adjusted earnings payout ratio and hints that the dividend is sustainable, at least for now. But what happens as cigarette volumes continue to decline? There's likely to be a tipping point when price increases exacerbate the problem and speed up the downtrend in the company's most important business.
That's supposed to be where the new categories come in, the area that management is focused on growing. Right now, these businesses contribute just 2% of the company's profit from operations. There's no question that British American Tobacco has to invest in these products, but they're a very long way from offsetting the declines in its most important business. Thus, the company's non-cigarette business is nowhere near the point where it could support the massive dividend all on its own.
No need to worry ... yet
Dividend investors don't need to worry about the safety of British American Tobacco's dividend right now. It has ample room to keep paying and time to grow its non-combustible businesses. But you can't buy this cigarette maker and forget about it. It has a long-term problem, and it hasn't yet found a way to solve it. The dividend could end up being a casualty if British American Tobacco's "new categories" plans don't play out as well as hoped. That suggests that conservative long-term dividend investors should probably err on the side of caution and avoid this high-yield stock.
