For decades, tobacco stocks were the cream of the crop when it came to investment performance. Despite years and years of volume declines in the United States and other markets, sellers of cigarettes had two things going for them that enabled their stocks to crush the market: global population growth and pricing power. This enabled the companies to deliver consistent earnings growth and return capital to shareholders with fat dividends.
The 2010s and 2020s have not been nearly as kind to these stocks. For example, industry leader British American Tobacco (BTI -0.51%) has posted a total return of just 6% over the last 10 years. The S&P 500 is up 230% over that same period.
Data by YCharts.
But perhaps investors are getting too bearish on British American Tobacco. Its valuation is close to an all-time low, and its dividend yield is pushing to new highs as shares keep falling. If you look at its underlying business, the financial results look fine too. Does that make British American Tobacco a safe dividend stock for investors in 2024? I think it might. Here's why.
United States volume declines, still growing revenue
British American Tobacco owns storied cigarette brands such as Camel, Lucky Strike, and American Spirit. These brands have struggled in one of the company's most important markets -- the United States -- with revenue down 7.4% year-over-year in the first half of 2023. This decline comes despite some hefty price increases. Investors have become worried about the highly profitable U.S. market, and they're likely wondering whether these steep declines will continue over the next few years.
Despite these troubles, British American Tobacco's overall cigarette revenue grew in the first half of 2023. How? Its non-U.S. segments posted mid- to high-single-digit revenue growth in the period. The overall cigarette segment only grew revenue 0.2%, so investors shouldn't expect much growth from this segment in the coming years.
Cigarettes and these legacy brands make up the vast majority of British American Tobacco's earnings power. In 2022, the company generated around $10 billion in free cash flow, using the current exchange rate of the U.S. dollar and British Pound. Even if the cigarette business doesn't grow from here, it should still be able to generate significant amounts of cash flow for the parent company each year.
New categories will contribute to profitability
If the trend of the last few decades continues, cigarette usage will only decline further around the globe. A terminally shrinking business is not ideal, and this reality has many investors worried about the future of these tobacco companies.
However, British American Tobacco has a plan to move beyond cigarettes, and it is executing quite well with its vision. There are three product categories (oral nicotine pouches, nicotine vapor, and heat-not-burn tobacco devices) British American Tobacco is investing in around the world, which has led to some explosive revenue growth for what it calls "New Categories."
Since 2019, new categories revenue has grown at an annual rate of 33%, hitting over $4 billion in trailing twelve-month revenue through the first half of 2023. Importantly, this segment has been a drag on profitability as the company spends heavily to increase its distribution around the world. Now, with increasing scale, this is starting to change with management guiding for the segment to break even in 2023. With similar unit economics to the legacy cigarette business, new categories should start generating significant profits for British American Tobacco in the second half of this decade.
Is the dividend payout sustainable?
At today's stock price of about $30, British American Tobacco has a dividend yield approaching 10%. With shares down 56% since the beginning of 2018, there's clearly pessimism around British American Tobacco stock and its ability to fulfill its dividend obligations.
I think these concerns are overblown. In 2022, British American Tobacco had close to $4 billion in free cash flow remaining after fulfilling its dividend payout. Yes, a lot of this went to paying down debt, which is something the company will need to continue doing over the next few years. But its business is still generating plenty of cash to both pay down debt and return cash to shareholders through dividends.
Investors should remember that new categories will go from a drag on free cash flow to a cash generator in the next few years. British American Tobacco may not be firing on all cylinders, but at current prices, it looks like a great stock for investors seeking generous and reliable dividend income.
