The 8.3% dividend yield on offer from British American Tobacco (BTI -0.51%) is likely to be very appealing to income-oriented investors. After all, the S&P 500 index is only offering a yield of around 1.4%. But yield alone isn't a good reason to buy a stock, and sometimes, a high yield is an indication that investors feel the dividend is at risk.
Here's why investors need to track one very important number at British American Tobacco (maker of Camel, Kent, Newport, and Lucky Strike cigarettes) as they monitor the safety of the company's dividend and consider whether or not to invest.
Cigarettes are big business for British American Tobacco
In the second quarter of 2023, British American Tobacco's combustibles segment, which is almost all cigarettes, accounted for just over 80% of sales. It is the most important business for the company and the one that drives its overall performance.
Image source: Getty Images.
It is nice to see management highlight its progress in growing what it calls "new categories." Sales here grew 26.6% year over year in the second quarter (on a constant currency basis), but the businesses that make up this segment are still too small to replace the cigarette operations. And it will likely be years before the new categories are even close to on par with cigarettes.
That's a problem because the zeitgeist today is decidedly against smoking cigarettes. And, at the same time, the company has been raising cigarette prices. There was an interesting dynamic when you look at overall revenue. Combustible sales rose a scant 0.2%, basically just holding the line. However, the 26.6% growth in new categories (its Vuse vaping products, Glo heating tobacco products, and Velo modern oral products) helped to drive overall revenue higher by 2.6% year over year.
On the right track, but a lingering problem
So it looks very clearly like British American Tobacco has been making good use of its cash cow cigarette business to expand into other areas. That's the good news and actually makes the company look better than peer Altria (MO -0.37%), which has had some notable failures as it looks to expand beyond cigarettes. Specifically, Altria took massive write-offs thanks to investments in marijuana and vaping.
But investors need to be careful here as well because British American Tobacco's cash cow is getting smaller and smaller. That's an industrywide issue, but it means that the cow's milk may not last forever. Some numbers will help illustrate this.
In the second quarter of 2023, British American Tobacco's volume in its combustibles business fell by 4.9% year over year. The vast majority of that came from its cigarette operations, which were down 4.7%. This is not a unique event.
In calendar year 2022, cigarette volumes dropped 5.1%, with overall combustible volume down 5.2%. In 2021, cigarette volume was off by 0.1%, with the combustibles group declining by 0.3%. That's not so bad, but it was really just an anomaly driven by the impact of the coronavirus pandemic. In 2020, cigarette volume slumped 4.6%, with total volume in the combustible segment falling 4.5%. The trend is not your friend here.
Watch British American Tobacco's volumes
You get the idea: British American Tobacco's cigarette operations are trapped in a downward trajectory. Yes, it has loyal customers (nicotine is addictive, after all). But it can only keep raising prices for so long before a tipping point is reached. When that happens, volume declines could speed up faster than price increases can offset the pain and might actually exacerbate the volume headwind. If British American Tobacco's new categories don't grow quickly enough, the company -- and its dividend -- could be in trouble. While the dividend looks safe now, this is not a "set it and forget it" passive income investment given the weak fundamental trends in its most important business.
