The big attraction for investors when it comes to British American Tobacco (BTI -0.51%) is its massive 9.8% dividend yield. Although that's an alluring figure for anyone trying to maximize their portfolio's income, yields that high usually come with some risk.
That's true here, too, but British American Tobacco is successfully working to move past its biggest risk. The potential for a multibillion-dollar windfall could help. Is now the time to buy this global cigarette giant?
The big problem for British American Tobacco
British American Tobacco's most important business is cigarettes. In 2023, the company's combustible division, which is predominantly composed of cigarettes, generated 81% of revenue. This is the company's largest business unit by a very wide margin.
Image source: Getty Images.
This is a problem because cigarette volume has been falling for years. In 2023, volume in the combustible division fell 5.5%. Cigarette volume, specifically, declined 5.3%.
That's a continuation of a trend. Cigarette volume was lower by 5.1% in 2022, 0.1% in 2021 (unusually strong, thanks to the impact of the coronavirus pandemic), 4.6% in 2020, and 4.7% in 2019. There's no indication that this trend is going to turn around, as smoking is increasingly frowned upon by consumers because of the health dangers it poses.
To offset the impact of falling volume, British American Tobacco has been increasing prices. That's allowed the company to continue to support sales, earnings, and dividends, despite the weak fundamentals of its most important business. But management knows that this tactic isn't a permanent solution -- it's merely a bridge that it can use to find a better solution.
British American Tobacco is building new categories
The really big news in 2023 was that British American Tobacco's new-categories division was profitable at the business-unit level. This division includes products like vapes, oral tobacco items, and heated tobacco.
Everything in this up-and-coming division isn't working, but enough of the new products are gaining traction that the overall story is quite positive. Notably, profitability was achieved two years ahead of management's expectations.
The real story here is that British American Tobacco wants to grow this division to offset the volume declines in cigarettes. If the company can do that, it may not need to push so hard on cigarette price increases.
A slower path of price increases would probably allow the company to milk profits from cigarettes over a longer period of time. In something of a virtuous circle, that would give British American Tobacco more time to build up its new-categories division.
This is where things get interesting. British American Tobacco is rumored to be in the process of selling a sizable stake in Indian conglomerate ITC, which itself has a sizable cigarette operation. This could bring in between $2 billion and $3 billion in cash, a huge windfall for British American Tobacco. Although there's no real way to know what the company would do with the money, it seems pretty clear it would go toward its effort to move beyond cigarettes.
That could be something as simple as paying down debt to strengthen the balance sheet, a move that would give British American Tobacco more financial leeway to buy non-cigarette businesses in the future. Or it could be used more directly, either to fund near-term investment in new-categories businesses or near-term acquisitions to bolster the division's growth prospects. Either way, this likely will be a huge boost to the company's efforts to reduce its reliance on cigarettes.
The best part of the story, however, is that British American Tobacco isn't planning to sell its entire stake in ITC. Thus, it could raise more cash in the same manner in the future.
Should you buy British American Tobacco?
There's no guarantee that British American Tobacco will sell any of its stake in ITC. But ITC represents an important financial asset that management can use to help support the company as the cigarette business continues to decline. Add in the strength of the new-categories division, and more aggressive investors might want to consider this ultra-high-yield stock for their portfolios.
That said, moderate and conservative investors should probably remain on the sidelines, as there's still a lot of work to be done to replace the roughly 80% of revenue that comes largely from cigarettes. If you buy today, you're basically doing so because you believe that British American Tobacco will, over the longer term, find a way to move beyond cigarettes. There's still a lot of work to be done on that front, even though the early progress has been strong.
