Is This Tobacco Giant's 8% Dividend Yield Too Good to Be True?

Dividends have fallen out of favor in recent decades. Driven by a transition to share buybacks and rising valuations across the stock market, major indices barely yield much for investors these days. For example, the S&P 500 currently has a dividend yield of only 1.5%, close to an all-time low. That is much lower than the 5%-plus yield you can earn owning U.S. Treasuries right now.

But what about investors looking for high-income assets in the stock market? There are a select few stocks with dividend yields higher than short-term Treasuries. Most are tobacco stocks such as British American Tobacco (BTI -0.51%). These companies are unloved by investors due to concerns around ESG (environmental, social, and governance mandates) and declining industry volumes. However, their dividend payouts continue to rise. 

Is British American Tobacco's 8% dividend yield sustainable? Or is this a declining company that is going to start feeling pain financially in the coming years? Let's take a closer look to find out. 

Declining volumes, rising prices

Cigarette usage, especially in the U.S., has steadily declined. In recent years, this has been accelerated by modern nicotine products such as nicotine pouches and vaping devices. As the owner of many large cigarette brands like Camel, Newport, and American Spirit, British American Tobacco has felt these declines. Total cigarette volumes for the company through the first half of 2023 were 293 billion sticks, down from 348.3 billion in the first half of 2018.

And yet, British American Tobacco's combustibles revenue was flat through the first half of 2023, at 10.8 billion British pounds in constant currency. How? It's simple: price increases. Through the last few decades, cigarette companies have steadily increased the prices of their products to counterbalance volume declines. What is underappreciated about this strategy is that it leads to profit margin expansion as you are getting the same amount of revenue on less volume and labor.

While it looks like cigarettes will eventually be a tiny market, British American Tobacco still has many years left to increase prices and stabilize its combustibles business. This should keep it generating plenty of cash flow that can sustain its 8% dividend yield while it is investing in new product categories. Speaking of which...

More than just cigarettes

British American Tobacco's management understands that cigarettes will eventually be a small business. In recent years, it has invested heavily in new, healthier nicotine categories to counteract volume declines. The most important are nicotine pouches and vapor.

The company owns one of the leading nicotine pouch brands called Velo, which has the dominant share in many European markets and plans to expand its distribution globally. Its e-vapor product Vuse has a 36% category market share in the U.S. and is launching in more and more markets around the world each year. Combined, British American Tobacco's new categories segment has grown its revenue at a 33% rate from 2019 through 2023, and now makes up 16.6% of the overall business.

Cigarettes are still going to drive the bus financially for at least the next few years, but investors should rest easy knowing that British American Tobacco is succeeding with these new nicotine products with much better long-term industry outlooks. As the division goes from losing money to generating cash, this should add even more of a margin of safety for the stock's high dividend yield. 

Can management get out of its own way?

When you combine the pricing power of cigarettes and the growth of new nicotine products, it is pretty clear that British American Tobacco's dividend should be safe. So what is stopping this stock from safely crushing the market? One word: management. 

The tobacco giant has seen some management blunders in recent years. Most notably, the U.S. government just fined the company over $600 million for violating sanctions against North Korea and selling products to the nation. This was clearly not smart behavior and places a negative light on the culture in the executive suite. After the news of this fine came out, the board of directors did replace British American Tobacco's CEO, but it is still a terrible look.

Management missteps are something to track, but they may not matter given how cheap this stock is. With an 8% dividend yield that looks sustainable for the next decade, British American Tobacco could be a fantastic stock for investors seeking a large margin of safety and steady income.