British American Tobacco: Dividend Resilience Meets Next-Gen Innovation in a Shifting Landscape

British American Tobacco (BTI) has long been a stalwart in the tobacco industry, underpinning its 29-year dividend growth streak with the steady cash flows of its core combustible cigarette business. Yet as regulators and consumers push for alternatives to traditional smoking, BTI is now doubling down on next-generation products like vaping devices and oral nicotine, aiming to transform itself into a leader in the $20 billion reduced-risk product (RRP) market. The question for investors is whether this pivot can sustain its dividend and justify its current valuation discount versus peers.

A Dividend Machine, But with a Safety Net?
BTI's dividend growth streak—now at 29 years—is one of the longest among global corporations. For 2025, it has raised its dividend by 4.1% to 245.10p per share, yielding 7.6% at current prices. This robust payout is fueled by its dominant combustible cigarette business, which still accounts for over 80% of revenue. Even as cigarette volumes decline, pricing power and cost discipline have kept profits resilient.

However, the dividend's safety hinges on two factors. First, its dividend cover (earnings per share divided by dividends per share) has dipped to 1.5x—below the conventional 2.0x threshold—due to higher dividend payouts and margin pressure. Second, the company faces a £6.2 billion litigation provision in Canada, where it is accused of misleading consumers about smoking risks. While this is a significant overhang, the provision is already reflected in its balance sheet, and BTI's £10.7 billion cash pile provides a buffer.

Next-Gen Products: Growth Engine or Regulatory Headache?
BTI's pivot to next-gen products is its long-term growth bet. The first half of 2025 saw 8.9% organic revenue growth in its “New Categories” segment, driven by strong performance in vaping (Velo Plus) and oral nicotine (modern oral products). The Glo Hilo heated tobacco device, launched in Serbia, has shown promising customer retention rates, and its phased global rollout could challenge Philip Morris's dominant IQOS platform.

Yet challenges remain. Illicit vaping products in the U.S. and Canada are undermining BTI's Vuse brand, and regulatory hurdles—such as Australia's ban on flavored e-liquids—are stifling growth. BTI's response is aggressive innovation: it plans to launch Vuse Ultra, a premium pod-based vaping system, in the U.S. this year, and expand its oral nicotine portfolio. Analysts estimate New Categories could hit 15% of revenue by 2026, up from under 10% today, fueling BTI's 3-5% revenue growth target.

Valuation: A Discounted Dividend Champion
BTI trades at a forward P/E of under 11, a 40% discount to Philip Morris (PM, 18.35) and 20% below Imperial Brands (IMB.L, 13.1). This reflects skepticism over its litigation risks and the uncertain trajectory of next-gen products. Yet BTI's 90%+ cash conversion ratio and £1.1 billion share buyback in 2025 underscore management's commitment to returning capital to shareholders.

Morningstar's £40 fair value estimate (versus a current price of £29.50) suggests significant upside, while its 7.6% yield is among the highest in the sector. Analysts' “Moderate Sell” consensus, driven by near-term forex headwinds and litigation concerns, may be overdone. BofA's $42.50 price target implies a 15% upside, arguing that BTI's defensive cash flows and undervalued next-gen pipeline are underappreciated.

Regulatory Risks and the Rate-Cut Tailwind
BTI's litigation in Canada is its largest single risk, though the provision may limit downside. Regulatory scrutiny of RRP products—such as bans on flavors or nicotine limits—is another wildcard, particularly in the U.S. and EU. However, BTI's hedging programs (covering 70% of forex exposure) and the Fed's potential rate cuts later in 2025 could amplify its appeal. A lower-rate environment typically boosts demand for high-yield stocks, and BTI's 7.6% dividend yield is a magnet in a 3.5% 10-year Treasury world. Historical backtests reveal that following Fed rate cuts between 2020 and 2025, BTI delivered an average return of 1.53% over the next 60 trading days, underscoring its resilience during periods of monetary easing.

Investment Thesis: Buy the Discount, Hedge the Risks
BTI is a compelling long-term play for investors willing to tolerate near-term volatility. Its dividend is secure in the short term, and its next-gen products are gaining traction in key markets. While litigation and regulation are risks, the stock's valuation already discounts these concerns.

Final Take:
British American Tobacco's blend of dividend resilience, next-gen growth, and undervaluation makes it a compelling contrarian bet. With a 22% discount to its five-year average P/E and a 7.6% yield, it offers both income and growth potential. Investors should consider dollar-cost averaging into the stock, while monitoring litigation developments and next-gen product sales. In a world of high yields and low rates, BTI's ability to adapt to a post-cigarette future could pay off handsomely.

Disclosure: This analysis is for informational purposes only and does not constitute financial advice. Investors should conduct their own research or consult a financial advisor.