Cigarette usage -- especially in the U.S. -- has been in steady decline for decades. In 1965, 42.4% of U.S. adults smoked cigarettes. In 2018, that rate had dropped to just 13.7%.
But did you know that despite a declining customer base, tobacco stocks have been some of the best performers over the past 50 years? At first, this dichotomy doesn't make sense, but the outperformance can be summed up with two words: pricing power. With low manufacturing costs and an addicted user base, tobacco companies have been able to raise prices to counteract volume declines, leading to steady earnings growth and inflation-resistant business models.
British American Tobacco (BTI 0.80%) is one of the leading tobacco companies, with brands such as Camel, Newport, and Lucky Strike. The stock has fallen precipitously in 2023 and now sports an appetizing dividend yield of about 8.8%.
Is the stock a great buy for income investors at these prices? Or is it a value trap? Let's take a look.
Cigarette cash cow, transition to reduced-risk products
Since 2017, when British American Tobacco bought Reynolds American, cigarette volumes have declined by 3.8% per year. But since that time period, group operating income in U.S. dollars has grown from $11.2 billion to $12.7 billion due to price increases across its cigarette brands. For example, in 2022 combustibles volume declined by 5.2% year over year, but prices were raised by 4.6% year over year, leading to only a slight revenue decline for the year.
Even though this has worked out for decades, if current trends hold, we are likely headed to a future with minimal cigarette usage. British American Tobacco executives understand this and are investing in tobacco-free products to sell to consumers looking for healthier nicotine products. Right now, these include three big products:
- Glo (tobacco that is heated but not burned),
- Velo (oral nicotine pouches), and
- Vuse (nicotine vapor).
The growth of these new categories has been impressive, with revenue up 37% year over year in 2022. Management expects these products to have positive profit margins by 2024, 5 billion British pounds ($6.2 billion) of revenue by 2025, and 50 million customers by 2030. In 2022, new categories revenue was 2.9 billion British pounds, with total customers growing by 4.2 million to 22.5 million for the year.
If the growth of new products continues, British American Tobacco should be able to further counteract volume declines in cigarettes and build a more resilient business for the long term.
Management missteps
If British American Tobacco is doing so well with its business transition, why has the stock fallen 19% in 2023, with the dividend yield at 8.8%? Most likely for a few reasons, stemming from diminished investor confidence in management.
Earlier this year, the U.S. Department of Justice slapped a $635 million fine on British American Tobacco for illegally selling products to North Korea, which is the subject of a U.S. trade embargo. This not only hurt the company financially, but it also suggests a serious lapse in business judgment.
On top of this, Chief Executive Officer Jack Bowles just announced he is leaving the company after just being hired in 2019. Replacing him is Tadeu Marroco, who has been with the company since 1992.
Beyond a lack of confidence in management, macroeconomic headwinds could start pressuring cigarette makers in the coming quarters. For example, Dollar General -- a big distribution partner for tobacco companies -- said its consumers are facing more economic pressure than it has seen in a long time. This could mean accelerated volume declines for cigarettes over the next few quarters, especially if brands keep raising prices at an aggressive pace. Time will tell how much it impacts British American Tobacco's income statement, though.
Is the dividend sustainable?
The good thing about buying a stock with an 8.8% dividend yield is that you don't need much growth or share price appreciation for the investment to work. You just need to have confidence the dividend will grow or not be cut by executives -- and you can take that return home to the bank each year.
It looks like British American Tobacco's dividend yield is in no danger of being cut. In 2022, the company generated $11.7 billion in free cash flow and paid $5.9 billion in dividends to shareholders, giving it a $5.8 billion cushion to maintain its dividend no matter if the business sees short-term economic pressure. Over the long term, tobacco-free products should become a much larger percentage of this business, making cigarette volume declines less of a risk every year from here on.
A sizable free cash flow-to-dividend payout cushion and a fast-growing new categories segment should give investors confidence that British American Tobacco's dividend is sustainable and could even rise in the years to come. Despite management blunders, this makes the stock an attractive opportunity for income investors after the recent price dip.
