The London Stock Exchange is home to a wide range of dividend shares, a collection of which have been hiking their shareholder payouts for decades. These Dividend Aristocrats are a popular destination of capital for many income-seeking investors. And their ability to continue paying out a larger amount each year makes them seem extremely safe as investments.
Arguably, two of the most popular in the UK are British American Tobacco (LSE:BATS) and National Grid (LSE:NG.). Both enterprises have been rewarding shareholders with ever-increasing dividends for more than 25 years. But can they continue to maintain this impressive track record moving forward?
The evolution of the tobacco industry
It’s no secret that cigarettes are addictive. And this has been a crucial advantage for firms like British American, which have been able to systematically increase prices in the face of falling volumes as consumers have steadily become more health-conscious.
That’s paved the way for impressive free cash flow generation. Sadly the share price has struggled to gain momentum as investors becoming increasingly more focused on ESG factors. But that’s also led to the stock now paying close to a 10% dividend yield – one of the highest in the FTSE 100.
So, despite being unpopular, is this secretly a gold mine for income investors? For the time being, that certainly seems to be the case. But zooming out to the long run, some uncertainty starts to creep in.
With regulatory restrictions becoming increasingly harder to comply with, the future of the cigarette industry looks bleak, at least in its current form. That’s why British American Tobacco has already been investing heavily in new non-cigarette product lines, such as vaping devices and heated tobacco.
These products are expected to become the dominant generator of revenue for this enterprise within the next decade. But whether they can produce the same level of cash flow as cigarettes currently do, is still unclear. Should the company fail in its transition, the group’s long dividend track record may finally come to an end.
Electricity demand is rising
National Grid is considered to be one of the safest dividend shares in the UK by many investors. And it’s not difficult to see why. Operating in a legal monopoly, the firm has next to no competition, making everyone in Britain dependent on its infrastructure.
The group is obviously subject to regulator oversight to prevent abuse. But even with these restrictions, it’s a highly cash generative business with strong demand. That’s how it’s managed to hike its dividend every year since 1996. But is it actually as ‘safe’ as many investors believe?
Building and maintaining national energy infrastructure isn’t cheap. And it subsequently caused the group to rack up an exceptional amount of debt — £42.99bn, to be precise. By comparison, the firm’s market capitalisation only stands at £38.7bn. And this leverage-heavy capital structure could prove quite problematic in the face of higher interest rates.
As higher interest expenses gobble up more cash flow and regulatory pricing restrictions prevent cost mitigation, the sustainability of its dividend could be questioned.
The bottom line
At the end of the day earning the title of Dividend Aristocrat is an impressive feat that not many businesses achieve. However, like any investment, even these safe-looking income opportunities carry risks. And investors need to carefully inspect whether they’re risks worth taking.
