Shares in British American Tobacco (LSE:BATS) currently come with a big dividend yield. That should put them on the radar of investors looking for a second income.
The big question though, is durability. Tobacco volumes are in decline, so the question is whether the company’s next generation of products are going to be able to pick up the slack.
Dividend coverage
I don’t often see dividend coverage – the gap between a company’s earnings and its dividend – as a useful metric. Mostly because it’s easy for investors to draw the wrong conclusion from it.
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British American Tobacco is one of the rare cases where I do think this is helpful though. The firm has sent out around the vast majority of its income to shareholders over the last 10 years. That means there’s not a huge amount of room for manoeuvre. If earnings start falling, the company won’t be able to maintain its dividend for long.
Cigarette volumes have been declining slowly, but I expect this to accelerate over time. So the firm’s going to need to replace that income to keep sending out cash to investors.
Next-generation products
Realistically, it looks like it’s going to have to be British Tobacco’s new category products that are going to have to come through. These include vapes, nicotine pouches and heated tobacco.
There’s evidence of strong growth in this part of the business. Since 2020, revenues from new products have grown at 33% a year and the division now makes up almost 20% of total sales.
The division also turned profitable recently. So if the strong momentum can continue, investors might find themselves collecting a second income for a long time.
There’s also another significant point to consider. If the company’s new products look like they might be able to sustain the dividend, I wouldn’t expect the yield to stay at 8%.
Consumer products
Right now, the market‘s clearly thinking of British American Tobacco as a declining tobacco business. Which is fair enough – that’s where around 85% of revenues come from.
If the company starts to look like a more stable consumer products business though, I expect this to change. The likes of Unilever and Haleon don’t have 8% dividend yields.
Their dividend yields are less than half this because long-term demand for their core products is more robust. And expect British American Tobacco to be similar if its business goes this way.
That implies the share price could double from here if smokeless products can ultimately support the current dividend entirely. That’s a big ask, but a huge potential reward if it can.
Margin of safety
The case for British American Tobacco shares comes down to whether smokeless products can replace enough lost cigarette income to justify the share price. I think it’s just too close to call.
From here, it wouldn’t take much to get me over the line. So I’ll be watching the December update very carefully for news about the growth of the new categories.
