The tobacco industry has faced a steep decline in the past two decades, but the world's top tobacco companies still offer some of the highest dividends among large-cap stocks. The big three of the industry – Philip Morris International (PM -1.11%), Altria (MO -0.37%), and British American Tobacco (BAT) (BTI -0.51%) – have an average annualized dividend yield of 7.75%. That's head and shoulders above the 1.4% average of S&P 500 listed stocks and it even tops the nearly 4.5% yield of the 10-year Treasury note.
However, income investors should be aware of some key issues before investing in these high-yield stocks. One of them is the significant difference in the share price performance of the big three in the past five years. Philip Morris stock has outperformed its peers by leading the transition to a smoke-free world and offering less harmful alternatives. Altria and BAT, on the other hand, have seen their shares stagnate despite their high yields.
BTI Total Return Level data by YCharts
This lackluster performance has made both Altria and BAT exceptionally cheap. BAT stock, in particular, has one of the most attractive valuations in the industry, with its shares trading at only 6.9 times projected earnings. This is an exceedingly low valuation for a blue chip stock that pays an impressive 8.42% dividend yield at current levels.
Is this ultra-high-yield dividend stock a safe bet for income investors? Let's take a closer look to find out.
Business overview, dividend sustainability, and outlook
BAT is one of the largest tobacco companies in the world, with a portfolio of popular brands such as Camel, Kent, Newport, and Lucky Strike. However, as the demand for traditional cigarettes declines in many markets over health concerns and regulations, BAT is investing heavily in its "new categories" segment, which includes products such as vapor products, heated tobacco, and oral nicotine.
In its most recent fiscal report, BAT reported a robust 26.6% growth in new categories revenue compared to the same period last year. The company expects this segment to contribute to its long-term earnings growth and to offset the decline in combustible tobacco sales. Analysts also forecast that BAT will achieve low single-digit growth in both earnings and revenue over the next two years.
However, there are some important challenges and risks associated with this strategic shift. Chief among them, these next-generation nicotine products tend to have lower margins and higher competition than traditional cigarettes, which means that BAT will likely have to invest more in marketing and innovation to maintain its market share and profitability.
Additionally, the regulatory environment for these products is still uncertain and evolving, which could pose potential hurdles or opportunities for BAT depending on the outcome. In other words, these tobacco alternatives may not prove to be a panacea for what ails the industry. Time will tell.
On a positive note, BAT's payout ratio stands at a reasonable 43%. The company, in turn, should be able to comfortably afford to continue to pay one of the highest dividends in the space for the foreseeable future -- even if margin compression eventually becomes an issue.
Verdict
BAT offers a tempting dividend yield that seems secure, despite the industry's persistent decline and strategic shift to less harmful products. That being said, the company's stock doesn't exactly leap off the page as a top buy. BAT's bargain basement valuation reflects the serious challenges in its core business and the fierce competition in key new product categories like heated tobacco. In short, this high-yield dividend stock could very well continue to underperform peers like Philip Morris, as well as the broader markets in the years ahead.
