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Is This 10% Yielding Tobacco Stock Finally a Buy?

In Business
February 25, 2024

The stock market has gotten its animal spirits back yet again. The S&P 500‘s price-to-earnings ratio (P/E) has hit 27, Nvidia has rocketed to one of the largest market caps in the world, and Super Micro Computer is up more than 750% in less than a year. We are living through an artificial intelligence (AI) boom, at least in the stock market, which has investors extremely optimistic about the future.

What if you want to fade the AI boom? For more conservative investors, now may be the time to hunt for steady dividend payers that can ride out the AI boom, which could eventually bust for greedy investors. Enter British American Tobacco (NYSE: BTI). The tobacco giant’s dividend yield is currently close to 10%, making it one of the highest dividend payers in the world at the moment.

The company is going through major troubles that have kept its stock underperforming for years. But with the dividend yield now so high, is it finally the time for investors to take the plunge? Let’s take a closer look and find out whether shares of British American Tobacco are a buy at these prices.

BTI PE Ratio Chart

BTI PE Ratio Chart

Worries about cigarette volume declines, federal menthol ban

British American Tobacco is a global player in the cigarette space, owning brands such as Dunhill, Camel, and Lucky Strike. Its combustibles segment — which is what the company calls cigarettes — generated $27.9 billion in revenue last year and contributed the majority of the company’s cash flows. The entire British American Tobacco business has generated over $10 billion in free cash flow every year for the last five years.

The problem is that cigarette volumes are drying up quickly in the United States, one of the company’s core markets. Combustibles volume declined 11.3% year over year in 2023 for the U.S. market, leading to a 6.4% revenue decline in constant currency. This region’s combustibles business topped $12.2 billion in revenue in 2023.

Things could look even worse over the coming years if the U.S. Food and Drug Administration (FDA) imposes a federal ban on menthol cigarettes. The new rule on these flavored products is being heavily considered by regulators and would have a big effect on British American Tobacco, whose brands are the leaders in this category niche. These major headwinds are why British American Tobacco’s stock is down to a cheap-looking 6.2. Investors are pessimistic about the sustainability of its earnings power, and for good reason.

Can vapes and nicotine pouches save the day?

The future of British American Tobacco’s cigarette business looks bleak, but these aren’t the only nicotine brands it owns. Through acquisitions and investments over the past few years, the company built up a sizable business in e-vapor and nicotine pouches, which are marketed as alternatives to traditional cigarettes.

These brands — which are grouped together in the “new categories” segment — generated $4.22 billion in revenue last year, up 17.8% in constant currency. Even better, new categories is now moving from an earnings headwind due to negative margins to an earnings tailwind as margins start to expand with more scale. New categories’ profit margin was positive for the first time in 2023, two years ahead of management’s previous goal. Over the next few years, these margins should continue to expand due to the phenomenal unit economics of nicotine products.

With strong growth and great unit economics, new categories might generate $1 billion to $2 billion in annual cash flow a few years from now. It won’t replace the entire legacy business overnight, but it can help if the other segments face even more headwinds in the future.

Yes, the dividend yield is sustainable (for now)

With such a depressed stock, British American Tobacco can earn solid returns for shareholders if it can just sustain its 10% dividend yield. You don’t even need price appreciation, and you’ll match the long-term return average of the S&P 500.

It looks like British American Tobacco not only can sustain its dividend, but should be able to grow its payout over the next decade. Even with big headwinds in the United States, the company’s organic revenue in combustibles grew by 1% in constant currency last year due to its exposure to strong international markets for the category.

This should help maintain its current free cash flow unless there is a drastic change to the operating environment. Management has paid down a lot of debt in recent years, bringing its leverage ratio to a much healthier level. Don’t forget about the coming contribution from new categories, which has now turned into a tailwind.

It looks like the company’s cash flows are not at risk of evaporating anytime soon. But British American Tobacco’s dividend payout is nowhere near $10 billion, either. The company paid $6.34 billion in dividends to investors last year, giving the company plenty of room to pay down more loans and raise its dividend if it just keeps its current cash flow intact. I think it is likely the company’s free cash flow will grow in the next few years as well.

Add it all together, and British American Tobacco looks like a safe dividend stock to buy right now.

Should you invest $1,000 in British American Tobacco right now?

Before you buy stock in British American Tobacco, consider this:

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Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Nvidia. The Motley Fool recommends British American Tobacco P.l.c. and Super Micro Computer and recommends the following options: long January 2026 $40 calls on British American Tobacco and short January 2026 $40 puts on British American Tobacco. The Motley Fool has a disclosure policy.

Is This 10% Yielding Tobacco Stock Finally a Buy? was originally published by The Motley Fool

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