Shares of British American Tobacco (BTI -0.51%) are down about 33% since peaking in early 2022, and they're down nearly 60% from their all-time high. On the surface, this poor performance makes sense. While demand for tobacco products is strong in some geographic regions, tobacco usage in the U.S. is in a perpetual decline. The company expects global tobacco industry volumes to drop 3% this year, with the U.S. driving much of that decline.
One of the main reasons to own British American Tobacco stock is the dividend. With tobacco volumes trending downward, investors are right to ask whether the dividend can be sustained, let alone grow. The relentless pessimism that has driven down the stock price has pushed up the dividend yield to nearly 10%. More often than not, ultra-high yields are a sign of trouble rather than opportunity.
In this case, British American Tobacco looks like a solid value and a dividend stock that's been unfairly beaten down. Based on its pessimistic valuation and its progress in diversifying away from traditional cigarettes, the stock has the potential to reclaim its all-time high and double from where it trades today.
A transformation in progress
The future of British American Tobacco is smokeless. The company is aiming to produce 50% of its revenue from noncombustibles like e-cigarettes, which the company calls "new categories," by 2035. There's a legitimate question that investors should ask: Will these new categories of products be as profitable as traditional cigarettes? While it's too early to say for sure, British American Tobacco is ahead of schedule on the profitability front.
British American Tobacco grew organic revenue by 3.1% in 2023. That growth was driven by higher pricing in the combustibles business coupled with 21% growth for new categories. While essentially all of the company's profits still come from combustibles, 2023 marked an inflection point for the new categories business. New categories turned a small profit for the year, with this goal being reached two years ahead of the company's original target.
Net categories generated revenue of 3.35 billion pounds in 2023, and the company is shooting to boost this metric to 5 billion pounds by 2025. Overall revenue growth will be sluggish this year due to macroeconomic conditions, with the company expecting low single-digit percentage organic revenue growth. The plan is to reach an organic revenue growth rate between 3% and 5% by 2026, along with mid-single-digit adjusted profit from operations growth.
A bargain dividend stock
British American Tobacco produced free cash flow of 8.36 billion pounds in 2023. This easily covered the dividend. After dividend payments there were still 3.3 billion pounds left over for other uses in 2023. One of those uses was debt reduction. The company is working to bring down its debt levels to provide increased resilience and flexibility.
Free cash flow is unlikely to rise by much over the next five years. The company expects to produce a cumulative free cash flow of 40 billion pounds over that period, which averages out to 8 billion pounds per year. The good news is that British American Tobacco can still afford to boost the dividend, particularly once it reaches its target for debt reduction.
What has to happen for shares of British American Tobacco to double? The company must prove to investors that its free cash flow is sustainable. Based on the average free cash flow expected over the next five years, British American Tobacco stock trades at a price-to-free-cash-flow ratio below 7.
British American Tobacco will continue to milk the declining cigarette business as much as it can, using those vast profits to invest in new categories. If the company can reach a point where profits from new categories are growing fast enough to offset any declines in the combustibles segment, the market could finally award the stock a more optimistic valuation multiple.
Reaching this point will take time, but long-term investors will receive a generous and sustainable dividend while they wait.
