Can the British American Tobacco dividend keep growing for decades?

Christopher Ruane sees large risks for the cigarette business. So why does he think the British American Tobacco dividend might still have years of growth ahead?

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A couple of decades ago, one of the attractions of buying shares in British American Tobacco (LSE: BATS) was the company’s juicy dividend, funded by massive cash flows. Fast forward 20 years and what has happened to the British American Tobacco dividend?

It has risen every single year over the past 20 years.

The most recent increase was this year’s 6% boost. Not only that, but the 8% yield is close to record highs.

The current weak share price (down 28% in five years) and high yield may suggest that many investors have doubts about the long-term outlook for the debt-laden producer of a product facing structural demand decline.

An alternative view is that, just as the dividend has grown annually for the past two decades, it could keep doing so.

As a British American Tobacco shareholder with skin in the game, I actually think the dividend could be set to keep growing. Here’s why.

Intent and capacity

The current management has signalled its commitment to raising the dividend annually (something known as a progressive dividend policy).

The recent increase demonstrates that in practice, while management comments on earnings conference calls are explicit about the intention.

Indeed, the company’s chief executive could not have been clearer on this point during the most recent such call. He told analysts, “We remain committed to continue our 25-year track record of consistent dividend growth, rewarding our shareholders through all economic cycles”.

But few managements stay in place for 20 years — and priorities can change.

Even if the intent remains consistent, sustaining dividend growth will require financial capacity.

Declining demand for key profit driver

In any given year, the company could simply borrow to fund dividend growth. Its adjusted net debt of £37bn makes me uncomfortable, but it is a reminder that the highly cash generative business can typically borrow money easily if it wants.

Longer term, though, sustaining dividend growth will depend on the company’s free cash flows. British American Tobacco has consistently targeted paying out around 65% of its earnings as dividends. That is a self-imposed target so it could be changed.

On one hand, declining cigarette sales are a key risk to the company’s ability to generate the free cash flow and earnings needed to keep growing its dividend. Cigarettes remain by far the biggest contributor to the company’s earnings. But the company sold 5.7% fewer cigarettes in the first half than the prior year period.

Reshaping income streams

On the other hand, the company still sells billions of cigarettes every week.

Its portfolio of premium brands gives it pricing power, helping to offset declining volumes. It is also possible to buy growth opportunities in a declining market through acquisitions, like British American’s takeover of US tobacco business Reynolds six years ago.

The company has been growing its non-cigarette business quickly. New category growth in the first half was in the double digits year on year and British American has only scratched the surface of the vaping market.

A lot can change in a short time, let alone decades. The company faces sizeable financial challenges, from managing its debt to dealing with declining cigarette sales. But I see at least a possibility that the British American Tobacco dividend could keep growing for decades.  

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

C Ruane has positions in British American Tobacco P.l.c. The Motley Fool UK has recommended British American Tobacco P.l.c. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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