The chief argument against owning any tobacco stock these days is undeniably solid: Smoking is on its way out. Although the prevalence of smokers has been dwindling for years, sheer population growth has kept the industry moving forward anyway. Now, however, smoking cessation efforts have finally and fully caught up with the habit. The World Health Organization believes the worldwide number of smokers currently stands at a little less than 1.3 billion, down from 2015's count of 1.32 billion, en route to an estimated 1.27 billion by 2025. Assuming this trend persists, the number will eventually reach levels that simply aren't big enough to keep tobacco companies in business.
Yet it may be far too soon for investors to give up on tobacco giant British American Tobacco (BTI +0.33%). Indeed, there are three key reasons you might even want to make a point of stepping into this prospect sooner rather than later.
1. British American is self-managing the demise of tobacco
With just a superficial look the backdrop is grim. Smoking is on the defensive, and cigarettes still account for more than 80% of British American's business -- a business that contracted nearly 5% during the first half of this year (as measured by unit volume), extending a trend that's been underway for some time now.
The company's at least partly responsible for the very headwind it's facing. Recognizing smokers are increasingly interested in kicking the tobacco habit, British American now offers a variety of vaping and tobacco-heating alternatives that are generally believed to be safer than outright inhaling smoke. Vuse and Glo are British American Tobacco brands of vaping and heated tobacco devices, respectively.
These new categories still only account for a fraction of the tobacco giant's business, and they may never fully replace traditional cigarette revenue. After all, vaping has its own health-related concerns.
However, with vaping product sales up 9% year over year through the first half of the year, while heated-tobacco product sales were up 15.7%, British American Tobacco could readily fend off the impact of smoking cessation efforts for a long time.
Let's also not forget that even if the World Health Organization's outlook is on target, that still leaves well over 1 billion smokers around for many, many more years. It might be a shrinking business, but it's shrinking at a snail's pace.
2. The stock's current dividend yield is enormous
Not only is the tobacco business shrinking at a snail's pace, but it also remains incredibly profitable despite the headwind. More than 40% of British American's revenue is regularly turned into operating income, while around 20% of its top line trickles down to its after-tax bottom line.
Profits are obviously important for any company to produce. Reliable profits like this are particularly important, however, for dividend-paying companies like British American to generate. Its dividend payments have to be funded somehow, after all.
NYSE: BTI
Key Data Points
To this end, only about two-thirds of the tobacco giant's earnings are dished out as dividend payments. The remainder can be reinvested in growth, new product development, to repurchase shares, or simply serve as a buffer against future fiscal turbulence.
And that's an important detail to understand about this stock's unusually high dividend yield of 9.6% -- it is sustainable. Although the stock's subpar performance keeping its yield so high understandably reflects the company's lack of long-term growth prospects, it also arguably undervalues British American Tobacco's capacity to continue dishing out cash payments for a long, long while.
3. Value stocks like this one may be about to shine
Last but not least, British American is a value stock at a time when value stocks could outperform most growth stocks.
Growth stocks' incredible market-leading performance over the past several years is almost intoxicating. But it wasn't the norm. Much of this strength was rooted in the fact that interest rates were at rock-bottom levels for the better part of the period between 2008 and early last year. Lower borrowing costs are beneficial for consumers and corporations alike, but they're especially beneficial to high-growth companies that can do something constructive with borrowed money.
Interest rates aren't so low any longer. Even if they do dwindle as expected beginning next year, they're still dwindling from levels not seen since 2007. Loans are going to remain relatively expensive for all borrowers. Slower-growth companies behind most value stocks, however, can handle it better even if only because investors' expectations of them are relatively low.
Rent rather than own
Even with these bullish arguments, interested investors should keep a cautious eye on British American Tobacco. It still faces a variety of challenges that can upend its stock, the chief of which is stronger headwinds on the cigarette front. For instance, just last week it booked a $31.5 billion write-down on its 2017 purchase of Reynolds American, pointing to the United States' increasingly challenging tobacco market. The stock took a sizable hit following the news, reminding shareholders that this is a business with an expiration date, even if that expiration date is years down the road.
The point is, no investor can afford to blindly view this name as a true "forever" holding.
If you understand that British American shares are just down too much of late and are a great source of dividend income at their current price, however, it's a compelling prospect with a little bit of potential for capital appreciation ahead.
It also doesn't hurt that there aren't a ton of other, more attractive options out there right now against a backdrop of high interest rates and with the specter of a recession on the horizon.
