A lot of investors like tobacco shares for the dividend potential they offer. Right now, British American Tobacco yields 6.1%. Competitor Imperial Brands has an even juicier dividend yield of 8.8%. That is just a little bit higher than US giant Altria, currently yielding 8.3%. So, if I want to get big dividends, does it make sense for me to buy tobacco shares at the moment?
The economics of tobacco
A lot of investors choose not to own such shares for ethical reasons. The industry is the source of millions of deaths worldwide each year. I think an investor should invest in line with their ethics. So while I am fine owning tobacco shares I know many people will not be.
What I like about this sector is its economics. Cigarettes are cheap to manufacture and distribute. Premium brands can help give companies pricing power, while the addictiveness of smoking means that short-term demand is fairly resilient even amid economic shocks. In the long term, the number of cigarette smokers is likely to keep falling, hurting revenues and profits. But that has already been happening for decades, and for now at least the industry looks robust to me. Last year, for example, British American Tobacco reported post-tax profits of £7.0bn.
Tobacco companies are trying to address the risk to their business from declining cigarette use, by developing new product lines like vaping, for example. That costs money – British American Tobacco expects its new lines of business to keep making losses until 2025. But as a mature industry, tobacco has little else in which to invest its profits. That means large free cash flows can help support big dividends.
Never ending risks
Last week, the US Food and Drug Administration effectively banned electronic cigarette Juul from the marketplace, although for now at least an appeal means the ban is on hold. But it concerned some investors. The worry is that if tobacco companies struggle to develop their electronic cigarette businesses, they will not be able to replace shrinking cigarette revenues.
That is a real risk, in my view. But it does not change the attractiveness of tobacco shares for me. The cigarette business remains a cash cow. I expect it to do so for the foreseeable future. Although volumes are set to keep declining, price increases may allow companies to keep making big profits. Manufacturers already have long experience of managing decline in cigarette markets.
What about newer product lines like electronic cigarettes? I expect tobacco companies to develop new revenue streams even amid challenges. After decades of legal and regulatory challenges to cigarettes, they have become experts at managing to cope in complex, regulated business areas.
I would buy tobacco shares
Clearly there are some real risks to tobacco companies. The core cigarette business may be in terminal decline, although it could still be around for decades yet. Newer businesses face regulatory hurdles, and for now at least are far less profitable than cigarettes.
But the industry is extremely resilient in the face of regulation. Its core product is cheap to make, addictive, and can be sold at a high profit margin. That helps fund big dividends. Even after the Juul ruling, I would happily buy tobacco shares for my portfolio now in the hope of big future dividends.
