British American Tobacco (BTI -0.51%) owns cigarette brands you likely know even if you don't smoke, including Camel, Newport, and Lucky Strike. Having recognizable brands is clearly a good thing, but that has to be juxtaposed against the longer-term shift away from smoking that has been taking place. While the company is working to adjust with the times, investors shouldn't overlook the risk of a declining cigarette business.
British American Tobacco's big draw
The one thing that most British American Tobacco investors are likely focusing on is the stock's huge 9.4% dividend yield. There's no question that it is attractive, given that the yield on the S&P 500 index is closer to 1.5%. However, a yield that high should be looked at with at least a little skepticism. The big question, obviously, is why so high?
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The answer isn't hard to find. At the midpoint of 2023, the company reported revenue for the entire company and revenue for what it calls "new categories." The new categories only make up around 12% of the total. That means that 88% of the company's top line is still tied largely to cigarettes.
This is a big problem. Just a little bit further down the mid-year report, investors will see that volume in the company's combustibles business, which is mostly cigarettes, declined 5.8% year over year in the first half of 2023. That's a bad sign, given the importance of this business. It isn't a one-time event; the decline has been going on for years.
Will price hikes and new business be enough?
British American Tobacco, like its peers, has been using price increases to offset volume declines. Given the addictive nature of tobacco, it tends to have pretty sticky customers. So, this is a reasonable approach. However, at some point, it is likely that prices will get so high that consumers will start to push back (perhaps switching to cheaper alternatives or quitting altogether). If that happens, the volume declines could accelerate materially.
This is where the new products come in. But at 12% or so of the top line, they are still a fairly modest contributor. That remains true even as the growth in the business is pretty strong. For example, in the first half of 2023, volume grew in three of the company's four non-combustible categories. The number of customers in the non-combustible group rose, by the company's estimate, around 6.6%.
That's good, but there's one small wrinkle. The release noted, "New Categories financial delivery significantly improved -- contributing £201 million increase to Group profit as losses reduce, on track to achieve our New Category profitability target in 2024." In other words, cigarettes are subsidizing losses in the new categories division and will continue to do so until at least next year. Unless that business starts to add to the bottom line in a meaningful way, British American Tobacco is still facing a major business problem.
A high-risk, high-yield stock
While British American Tobacco can still afford its dividend and will likely be able to continue doing so for at least a little while longer, there are dark clouds on the horizon. At this point, however, there isn't much in the way of a silver lining, either, given the still-small size and lack of profits in its New Categories business. If you are looking to create a passive income stream for the long term, British American Tobacco's big yield is probably too big a risk to bother with.
