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In some respectsBritish American Tobacco (LSE:BATS) could be considered the perfect passive income stock.
Currently (August 30) it is yielding 8.3%, well above the average for the FTSE 100 Index of 3.8%.
And for a quarter-century, it has increased its payout year after year, meaning it qualifies as a dividend aristocrat.
| Financial year | Annual dividend (pence) | Share price as of December 31 (pence) | Produce (%) |
|---|---|---|---|
| 2018 | 195.2 | 2.500 | 7.8 |
| 2019 | 203.0 | 3.232 | 6.3 |
| 2020 | 210.4 | 2.708 | 7.8 |
| 2021 | 215.6 | 2.734 | 7.9 |
| 2022 | 217.8 | 3.282 | 6.6 |
| 2023 | 230.9 | 2.296 | 10.1 |
However, despite being a classy action, I wouldn't touch it with a stick.
Let me explain.
An ATM
British American Tobacco has been able to pay generous dividends thanks to its ability to generate large amounts of cash. Selling a product that is cheap to manufacture and highly addictive is one way to ensure a healthy bank balance and solid cash flows.
To further help matters, traditional cigarettes are easy to manufacture and the basic design has not changed in decades, meaning there has never been a need to spend significant amounts of money on product innovation.
Until now.
A different future
The tobacco industry is in transition.
As traditional cigarettes fall out of fashion, companies are putting greater emphasis on vapes and other reduced risk products (RRPs). British American Tobacco envisions a smoke-free world where 50% of its revenue comes from RRPs by 2035.
But this requires significant investment. These new category products are more expensive to manufacture and are likely to require ongoing innovation and development to remain relevant.
And there is still a long way to go before they can replicate the financial success of cigarettes. In the six months ended June 30, 2024, the smoke-free range contributed 17.6% of revenue but just 2.3% of operating profit.
For this reason, I suspect that BAT's status as a Dividend Aristocrat will not last. That said, the decline in traditional cigarette sales will be slow, so I don't think there is any imminent threat to the payout.
However, there are growing concerns about the safety of RRPs. The World Health Organisation says vaping is banned in 34 countries, including India and Brazil.
These restrictions could mean that the increase in revenue from non-fuel products will not compensate for the loss of revenue due to the decline in traditional sales. If this happens, I have every confidence that both the company's share price and dividend will fall.
And of course, many ethical investors want nothing to do with the sector, meaning an estimated 20% of funds will never invest in the company.
Good value for money?
If I didn't have these concerns, I would be tempted by the low valuation of the stock.
For the year ending 31 December 2024, analysts are forecasting earnings per share of 359.7 pence. This implies a forward price-to-earnings ratio of 7.9. That's a cheap price for a FTSE 100 stock that offers a yield more than double the index average.
And this is in line with its closest rival.
Imperial Marksthe other Footsie tobacco company, currently trades on a forward earnings multiple of 7.3.
Its yield is 7.2%.
This tells me that other investors have similar concerns about the long-term viability of the industry.
Shareholders demand generous levels of passive income to offset the perceived additional risk associated with holding these stocks in their portfolios.
Even with a yield of 8.3%, I am not tempted to invest in British American Tobacco. It is too risky for me.
I think my money would go away.