Central bank interest rates have risen significantly in the last few years. This has led to banks and financial institutions offering close to 5% in annual interest payments -- sometimes even higher -- on consumer savings accounts versus close to 0% a few years ago. As long as you fall within the guidelines, these accounts offer federally insured and, therefore, riskless interest payments to savers looking to build for retirement.
For dividend investors, this raises the hurdle of an attractive dividend stock. Why buy a stock yielding 2% with little dividend growth when you can get a 5% return without taking any business risk? Dividend stocks need to either have an attractively growing dividend, a high dividend yield, or both to beat the basic savings account these days.
One stock that has fallen recently is British American Tobacco (BTI -0.51%). The tobacco giant and sin stock conglomerate now has a dividend yield approaching 10%, which looks attractive even in the face of a 5% risk-free interest rate. Is now the time to take the leap and buy some shares?
BTI Total Return Level data by YCharts.
The good: pricing power, expanding beyond tobacco
Tobacco volumes have been in decline for decades. With public pressure, advertising bans, and consumers cognizant of the negative health effects, fewer people are now smoking cigarettes around the globe. Famous brands, such as Newport, Camel, and Lucky Strike, populate the British American Tobacco brand portfolio, leading to a consistent rate of unit declines. This is obviously a headwind for the business.
However, cigarette companies have generally been able to counteract volume declines with price increases to stabilize or even grow revenue. For example, in the first half of 2023, British American Tobacco saw combustibles (i.e., cigarettes) volume decline by 5.8% year over year to 293 billion sticks.
In that same period, the company's revenue grew by 0.2% in constant currency and by 1.8% in its local currency, the British pound. With over a billion smokers worldwide, British American Tobacco should have many years left to raise prices in the face of volume declines, just as it has for the past 30 years.
On a consolidated basis, British American's revenue is growing even faster. In the first half of 2023, revenue was up 2.6% year over year in constant currency to 13.2 billion British pounds, around $16 billion. Why? The higher growth is coming out of its risk-reduced products, such as nicotine pouches and nicotine vapor products. Total new categories revenue was 1.66 billion British pounds through the first half of 2023 and grew 29% year over year.
While only a small part of the business today, this category has a long runway to grow and should help further counteract volume declines from the cigarette segment. By 2025, management expects the new categories segment to hit 5 billion British pounds in annual sales.
The bad: foreign exchange, North Korea, rising debt levels
Pricing power and the growth of net categories have been great, but there have been a lot of missteps at British American Tobacco in recent years. You don't get to a dividend yield of 10% firing on all cylinders. In fact, the stock has a negative total return of 4% over the last 10 years compared to 184% returns for S&P 500 index investors. That is some heavy underperformance.
A few things have gone wrong. First, for U.S. investors -- hence the S&P 500 comparison -- the company has faced major foreign exchange headwinds as the U.S. dollar continues to appreciate versus many other countries. This makes revenue growth less meaningful and is something outside the company's control. While hard to predict, it seems like the worst may be over from a foreign exchange perspective. The last few years were historically strong for the U.S. dollar and are unlikely to repeat.
Second, management has made some pretty bad missteps. The company is paying a $635 million fine for violating U.S. sanctions against North Korea and selling to the country, an indefensible blunder. There have been other mistakes as well. So much so that the board recently replaced CEO Jack Bowles with CFO Tadeu Marroco, likely due to the North Korea scandal coming to light. The market has little confidence in this management team, which any prospective investors should take into consideration.
Lastly, investors may be concerned with a high debt level, especially with rising interest rates making interest payments on that debt more expensive. For example, in the first half of 2023, British American Tobacco paid 921 million British pounds in interest expenses, or 15.5% of its 5.9 billion in operating earnings. Interest expenses will likely continue to eat into the company's earnings and could present a headwind to the business going forward.
Is the 10% dividend sustainable?
So, there's some good news and some bad news with British American Tobacco. But the question investors need to ask is whether, at close to a 10% yield, the current dividend payout is sustainable. If it is, the stock will likely do well over the long haul and generate some solid income for shareholders.
Let's run the math to see what the numbers spit out. In the first half of 2023, British American Tobacco generated 5.9 billion British pounds in operating earnings. Subtract 921 million in interest expenses and 1.27 billion in taxes and you get 3.11 billion British pounds in profits after interest and taxes, which can go to paying the dividend. In the first half of the year, the company paid investors 2.479 billion British pounds in dividends, or 80% of its bottom-line profits.
From my seat, this looks sustainable, especially if the new categories segment continues to grow at a healthy double-digit rate and consolidated profits stay flat or grow. Despite some blunders and high debt levels, British American Tobacco looks like a solid dividend play, with its yield approaching 10%.
