While FTSE shares haven’t delivered the highest level of growth lately, their ability to keep paying dividends makes them a terrific source of passive income. At least, that’s true in some cases. Sadly, not every high yield has been sustainable. And just recently, the FTSE 100‘s dividend leader in terms of payout – Vodafone – announced a cut.
Today, one of the largest yields offered in the UK’s flagship index comes from British American Tobacco (LSE:BATS). Shares of the cigarette empire are currently rewarding shareholders with a yield of just over 10%.
That would mean a £5,000 investment today could deliver an extra £500 in my pocket each year. And if I were to reinvest these proceeds, I could end up with considerably more in the long run.
However, is this truly sustainable? Or will management be announcing a dividend cut in the future, just like Vodafone did earlier this month? Let’s take a look.
Volatile earnings, solid cash flow
Shareholders of British American Tobacco have been holding their breath for a few years now. As a mature industry titan, the company has a reputation for consistently executing share buybacks. However, in light of higher interest rates, this policy was put on hold until leverage was brought back under control.
As part of this strategy, the firm’s in the process of selling its £14.7bn stake in ITC – an Indian conglomerate. So far, £1.5bn’s been raised. And it subsequently enabled management to trigger the long-anticipated return of share buybacks.
But the real concern is the state of its cigarette business. With increasingly strict regulations surrounding tobacco products entering legislation worldwide, the longevity of its core operations has come into question. This was made particularly prominent following the recent £25bn impairment charge on its US brands that sent its bottom line plummeting.
It’s important to note that impairment charges are ultimately paper losses that don’t affect cash flow. As such, the actual money moving through its operations continued to remain robust. But with the harmful effects of smoking pushing ever-increasing regulation and restrictions, the clock seems to be ticking for the company and its cash flows.
The need to transform
Management isn’t blind to the shifting landscape. And the company’s already been preparing for years for the future in which cigarettes are no longer being sold. This is where its new-categories division enters the picture, which contains products such as heated and oral tobacco as well as vaping devices and cartridges.
Sales of this segment grew by almost 16% in its latest results and has already started turning a profit two years ahead of initial expectations. Today, they represent 12.3% of the firm’s overall top line. But based on current guidance, this could reach as high as 50% by 2035 as it phases out its legacy cigarette products.
Assuming this transformation is successful and no further spanners are thrown into the works, it seems that British American Tobacco’s dividend is here to stay.
