Can British American Tobacco's Non-Cigarette Ventures Sustain Its 7% Dividend Yield?

British American Tobacco (BAT) has long been a staple in the portfolios of income-seeking investors, thanks to its historically high dividend yield. As of November 14, 2024, the company boasts a dividend yield of 8.48%, significantly higher than the average S&P 500 stock yield of 1.2%. However, the sustainability of this yield is increasingly under scrutiny as the company faces declining cigarette volumes and the need to pivot towards non-combustible products. This essay will delve into whether BAT's non-cigarette ventures can sustain its 7% dividend yield, providing a comprehensive analysis for investors.

The Current State of BAT's Dividend

British American Tobacco's dividend yield is undoubtedly attractive, but the sustainability of this yield is a different story. The company's dividend payout ratio, which measures the proportion of earnings paid out as dividends, was above 100% in 2024 when considering reported earnings. This means BAT paid out more in dividends than it earned, a concerning sign for long-term sustainability. However, when adjusted earnings are considered, the payout ratio was 66%, suggesting that the dividend is sustainable in the short term.

The Shift to Non-Combustible Products

BAT's strategy to transition to a predominantly smokeless business is evident in its investment in new categories such as vaping products, heated tobacco, and modern oral tobacco. As of December 31, 2024, new category revenue accounted for 17.5% of the company's total revenue, up from 16.5% in the previous fiscal year. This increase is driven by strong volume-led revenue growth, particularly from products like Vuse and Velo. The new categories achieved profitability in 2023, two years ahead of the original target, contributing a £398 million increase to Group profit at constant rates of exchange.



Financial Metrics and Ratios

Several key financial metrics and ratios indicate the sustainability of BAT's dividend yield. These include the dividend payout ratio, dividend yield, earnings per share (EPS), and cash flow. As of 2024, BAT's free cash flow was £79.01 billion, and the adjusted net debt/adjusted EBITDA decreased by 0.13 times to 2.44 times. This indicates that the company has sufficient cash flow to cover its dividend payments, but the high debt levels could pose a risk if earnings continue to decline.

Growth Prospects for New Categories

The growth prospects for BAT's new categories are promising. The company's strategy is to build a predominantly smokeless business, with a target of 50% of revenue from Non-Combustibles by 2035. This is supported by continued investment in innovation and capabilities that support strategic delivery. For example, BAT's corporate venture fund, Btomorrow Ventures, has launched its second fund with a £200 million commitment to focus on wellbeing and stimulation businesses, further accelerating BAT’s transformation journey.

Red Flags to Watch

Despite the promising growth prospects for new categories, there are several red flags that investors should watch. The company's reported diluted EPS for 2023 was -646.6p, which indicates a significant loss. Additionally, the company's revenue for 2024 was £25.867 billion, a decrease of 5.2% compared to 2023. While organic revenue growth was 1.3% at constant exchange rates, driven by an 8.9% increase in revenue from new product categories, the overall decline in revenue is a concern.

Alternatives if Rates Rise

If interest rates rise, high-yield dividend stocks like BAT could face additional challenges. Investors may want to consider alternatives such as dividend aristocrats or growth stocks that offer a more stable dividend yield. Additionally, diversifying across yield tiers can help mitigate risk and provide a more balanced portfolio.

Conclusion

In conclusion, while British American Tobacco's dividend yield is currently high and sustainable based on its cash flow and adjusted earnings, the company faces significant challenges due to declining cigarette volumes and the need to invest in new product categories. The high dividend payout ratio and the significant loss reported in 2023 are warning signs that the dividend may not be sustainable over the long term if the company cannot successfully transition to new categories. Investors should closely monitor BAT's financial performance and consider diversifying their portfolios to mitigate risk.