The stock market is a popularity contest in the short run, and right now, shares of British American Tobacco (BTI -0.51%) are losing badly. The stock is down more than 50% from its all-time high as the company navigates an ongoing decline in cigarette consumption.
British American Tobacco is still a growing company, though, and it has a strategy in place to keep revenue and profits rising even as the world shifts away from cigarettes. For investors willing to bet on the beaten-down stock, a high dividend yield offers a nice incentive.
New products lead the way
British American Tobacco is the quintessential sin stock. The negative health impacts of its products may deter some investors from considering this high-yield dividend stock. The fact that cigarette use is in perpetual decline, particularly in the United States, is another valid reason to stay away.
But looking past these issues, British American Tobacco is an inexpensive, high-yield dividend stock with decent if somewhat uncertain long-term growth potential. Combustibles, a category that includes cigarettes, are still the company's bread and butter. Organic volumes were down 5.4% for this category in 2022, and continued declines are likely. However, the company has been able to boost prices to offset this ongoing decline. Total organic combustibles revenue was down just 1.1% last year.
Noncombustibles will be the company's long-term growth engine. Revenue from what British American Tobacco calls new categories, which include vapor products and modern oral products, is soaring. New category revenue jumped more than 40% in 2022 to 2.9 billion pounds, accounting for more than 10% of total revenue. The goal is to bring this revenue to 5 billion pounds by 2025, and the company expects the fast-growing segment to turn a profit in 2024.
British American Tobacco expects organic revenue growth of 3% to 5% in 2023 thanks to this strong new category growth. And even as combustible sales decline, the company remains immensely profitable. Operating profit came in at 10.5 billion pounds in 2022, good for an operating margin of 38.1%. Based on its 2022 earnings, the stock trades at a price-to-earnings ratio below 10.
The dividend is particularly attractive. Based on the most recent dividend payment, the American Depository Shares offer a dividend yield of about 8%. The dividend is well covered by cash flow. The company generated 8 billion pounds of free cash flow in 2022, and less than 5 billion pounds was used for dividend payments.
Don't ignore the risks
There are some risks associated with British American Tobacco that shouldn't be ignored. First, the company will eventually reach the limits of its pricing power for combustible products. As cigarette use wanes, British American Tobacco may find that higher prices push customers to competing products.
Second, it's not obvious that profit margins for new-category products will be as lofty as for combustibles. British American Tobacco has a strong slate of brands, including Camel, Kent, and American Spirit. The company will need to replicate this success outside of combustibles.
Third, British American Tobacco also has a lot of debt, which may be problematic in a rising-interest-rate environment. Debt totaled 43 billion pounds at the end of 2022, and the company shelled out about 1.6 billion pounds in annual interest payments. This isn't a problem right now, but interest payments could rise in the future as debt is refinanced at higher rates.
Despite these risks, the bar for British American Tobacco to produce positive results for investors is low. If the company can hold its ground on revenue and profits as it diversifies into noncombustibles, the dividend alone can provide a solid return. And if British American Tobacco manages to grow the bottom line over time, stock price appreciation will probably add to the tally.
British American Tobacco looks like a great addition to any dividend-focused portfolio. The rock-bottom valuation may not stick around forever, so now is a good time to buy the stock.
