Tobacco companies have proved to be some of the steadiest investments for income investors over the last several decades. There are many reasons for this, such as the addictive nature of cigarettes, the pricing power the companies have, and the profitability of tobacco.
Investors who don't have ethical qualms about the industry should consider British American Tobacco (BTI 0.51%), one of the world's most dominant tobacco businesses. Let's look into its fundamentals and valuation to better understand the case for buying the stock.
Brands that can navigate a changing industry landscape
As more consumers have become aware of the health effects of smoking, cigarette sales volumes have been in perpetual decline throughout most economically developed countries. But British American Tobacco has a lot going for it that makes me confident the company will be just fine.
Over the long term, newer, noncombustible products are the future of the tobacco industry. The health problems caused by smoking tobacco will leave consumers wanting options that are potentially less harmful.
British American's most promising products in this regard are its vape brand Vuse, tobacco-heating brand Glo, and oral nicotine pouch Velo. They are why sales of noncombustible brands grew 33% annually from 2018 to 2022, and now account for nearly 15% of the company's total revenue.
The company's total customer base of 22.5 million for its noncombustible products at the end of 2022 was less than half of its 2030 target of 50 million. So these new product categories will be a major growth driver as the years pass.
In the meantime, British American Tobacco's cigarette brands like Camel and Pall Mall can help stabilize the company as it transitions toward its newer product categories.
For these reasons, analysts believe that the company's earnings will grow by 11.8% annually over the next five years. That's meaningfully better than the tobacco industry average of 7.7% as a whole for that time period.
Image source: Getty Images.
A well-covered payout
At more than five times the S&P 500 index's 1.6% dividend yield, British American's 8.6% yield would seem too good to be true on the surface. But digging deeper, the payout looks viable for those who are more focused on seeking income rather than capital appreciation.
The dividend payout ratio is expected to come in at just 54.6% for the next 12 months. Considering tobacco companies need minimal capital to maintain their businesses, that leaves British American with plenty of funds to strengthen the business through additional investment and acquisitions. This is why the dividend should slowly and steadily rise over the long run.
The stock is deeply discounted
Shares have greatly lagged the S&P 500 index in the past five years: A $10,000 investment in British American five years ago would now be worth just over $9,000 with dividends reinvested, while the same investment in the index would be valued at nearly $17,000 with dividends reinvested.
BTI total return level, data by YCharts.
Despite the encouraging evidence to the contrary, the market doesn't seem to be convinced that British American Tobacco can own the future of its industry. But at the current beaten-down forward price-to-earnings (P/E) ratio of 7, these risks are arguably priced into the stock given the tobacco industry's average forward P/E of 11.7.
Such a significant discount to its industry explains why analysts have an average 12-month price target of $53, which would be a staggering 63% upside from the current $33.
