A super-high dividend yield can often be a sign of trouble. That's not the case for AT&T (T 1.02%) and British American Tobacco (BTI -0.51%). AT&T is having success winning subscribers and growing its fiber internet business, and it recently bumped up its free-cash-flow outlook for the year.
British American Tobacco is a riskier stock as the company tries to balance slumping demand for cigarettes and soaring sales on non-combustibles. But so far, it's making it work and sustaining its sky-high dividend.
For dividend investors looking for inexpensive stocks with high yields that appear sustainable, AT&T and British American Tobacco are good bets.
AT&T
A rally over the past few months has pushed shares of AT&T up and the dividend yield down, but the telecom giant still sports a generous dividend yield. Based on the most recent dividend payment, AT&T stock currently yields about 6.9%.
That dividend looks a lot safer today than it did earlier this year. In 2022, AT&T produced just $14.1 billion of free cash flow, far below the company's initial guidance. A combination of higher capital spending, delays in collecting customer payments, and other factors reduced how much cash AT&T generated for the year. Going into 2023, AT&T's guidance calling for $16 billion of free cash flow was, for good reason, not taken as gospel by investors.
AT&T's dividend costs the company about $8 billion annually. The less free cash flow, the less money AT&T can use to reduce its debt. One thing that likely kept the stock grounded for much of 2023 was the expectation that AT&T might fall short of its guidance, potentially putting pressure on the dividend.
The good news is that AT&T's free-cash-flow generation appears to be on solid ground. Along with its third-quarter report, AT&T boosted its free-cash-flow outlook to $16.5 billion. Subscriber gains in the wireless business had been slowing in previous quarters, but in the third quarter, growth accelerated, average revenue per user ticked up, and churn remained low. The company's fiber internet business also continued to grow steadily.
AT&T stock trades for just 7 times the free-cash-flow guidance. With such a beaten-down valuation, it won't take much good news to send the stock higher. Add in the near-7% dividend yield, and you have an investment that should provide solid returns in the long run.
British American Tobacco
British American Tobacco is up against a chronic decline in demand for cigarettes. Cigarette volumes were down 5.7% year over year in the first half of fiscal 2023, although higher prices helped push up revenue. The company is wildly profitable, with an operating margin of 44.2% in the first half of the year. Those profits are necessary to fund British American Tobacco's generous dividend, which currently yields nearly 9%.
British American Tobacco is in a race against time. As sales of cigarettes erode, the company must grow sales of newer products, like e-cigarettes, quickly enough to offset that decline. The company must also generate a hefty profit from these new products, something that's still a work in progress. That will require the same kind of brand loyalty seen in the traditional cigarette market, which is not a given.
So far, British American Tobacco is making it work. Total revenue grew 4.4% year over year in the first half, with revenue from new categories surging by 26.6%. The company is on track to hit its target of 5 billion pounds of new category revenue by 2025 and to turn a profit from new categories in 2024.
There's plenty of uncertainty surrounding the tobacco industry and British American Tobacco, and that's one reason the stock appears so cheap, with a price-to-earnings ratio in the single digits. If the company can prove to investors that it can keep revenue growing, at least on average, by leaning into new products and boosting cigarette prices, the stock could be in for a major recovery. Shares of British American Tobacco are down more than 50% from their all-time high.
The company's strategy could fail, leading to slumping profits and likely lower dividend payments. That's a risk investors must take to capture the potential upside if things go according to plan. British American Tobacco is far from a sure thing, but it's a great way to bet on the potential of non-combustible products, like e-cigarettes, while receiving a lofty dividend.
