Despite an 8.3% yield, I wouldn’t touch this popular passive income stock with a bargepole!

In some respects, British American Tobacco (LSE:BATS) could be considered the perfect passive income stock.

It’s currently (30 August) yielding 8.3%, well above the average for the FTSE 100 of 3.8%.

And for a quarter of a century, it’s increased its payout year-on-year. This means it qualifies as a Dividend Aristocrat.

However, despite being a classy stock, I wouldn’t touch it with a bargepole.

Let me explain.

A cash machine

British American Tobacco has been able to pay generous dividends because of its capacity to generate lots of cash. Selling a cheap-to-make, highly-addictive product is one way of ensuring a healthy bank balance and strong cash flows.

To help matters further, traditional cigarettes are easy to manufacture and the basic design hasn’t changed for decades. This means there’s never been a need to set aside significant amounts of cash for product innovation. 

Until now.

A different future

The tobacco industry is in transition.

As traditional cigarettes fall out of fashion, companies are placing a greater emphasis on vapes and other so-called reduced risk products (RRPs). British American Tobacco envisages a smokeless world with 50% of its revenue coming from RRPs, by 2035.

But this requires significant investment. These New Category products are more expensive to make and are likely to require continual innovation and development to keep them relevant.

And there’s a long way to go before they replicate the financial success of cigarettes. For the six months to 30 June 2024, the smokeless range contributed 17.6% of revenue but only 2.3% of operating profit.

For this reason, I suspect BAT’s status as a Dividend Aristocrat is not going to last. Having said that, the decline in traditional cigarette sales will be slow so I don’t think there’s any imminent threat to the payout.  

But there are increasing concerns about the safety of RRPs. The World Health Organization says that vapes are now banned in 34 countries, including India and Brazil.

These restrictions could lead to increased revenue from non-combustible products failing to compensate for the loss of income due to declining traditional sales. If this happens, I’d be very confident that both the company’s share price and dividend will fall.

And of course, many ethical investors don’t want anything to do with the industry. This means there’s an estimated 20% of funds that will never invest in the company.

Good value?

If I didn’t have these concerns, I’d be tempted by the low valuation of the stock.

For the year ending 31 December 2024, analysts are forecasting earnings per share of 359.7p. This implies a forward price-to-earnings ratio of 7.9. That’s cheap for a FTSE 100 stock that’s yielding more than twice the index average.

And this is in line with its closest rival.

Imperial Brands, the other tobacco company in the Footsie, is currently trading 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 are demanding generous levels of passive income to compensate for the perceived additional risk associated with having these stocks in their portfolios.

Even with a yield of 8.3%, I’m not tempted to invest in British American Tobacco. It’s just too risky for me.

I think my money would go up in smoke.