Is British American Tobacco plc An Annuity Alternative?

Annuity giant Legal & General expects the UK annuity market to halve in size following the changes announced to pension rules in this year’s Budget.

That means that the £12bn annuity market could shrink to just £6bn — leaving an extra £6bn per year in the hands of investors, many of whom are likely to invest their pensions in dividend stocks.

british american tobacco / imperial tobaccoIn this article, I’m going to look at whether British American Tobacco (LSE: BATS) (NYSE: BTI.US) could be a suitable stock for long-term income seekers — or whether the uncertain future of the tobacco industry makes BAT a less suitable choice for retirement investors, despite its 4.3% yield.

Making more from less

BAT’s record since 2008 certainly doesn’t suggest that its business model is living on borrowed time.

The tobacco giant’s operating profits have risen by an average of 9.1% per year since then, rising from £3.5bn to £5.5bn in 2013.

Dividend growth has followed, averaging 11.2% over the same period — leaving long-term shareholders enjoying an annual payout that’s almost double what they were receiving in 2008.

Yet BAT’s business is shrinking. Cigarette volumes fell by 2.7% in 2013, an increase on the 1.6% decline seen in 2012.

Keep it in context

However, despite BAT’s falling sales, it’s worth remembering that the firm sold 676 billion cigarettes in 2013. Sales of the group’s key ‘global drive brands’ rose by 1.9%, suggesting that an increased focus on key brands is paying off.

Another sign that BAT’s business is in rude health is BAT’s operating margin, which rose by 1% to an incredible 38% last year.

And that’s the kicker: BAT’s profitability means that it generates vast amounts of free cash flow — £3.5bn in 2013, to be exact. That money was all paid straight back to shareholders, thanks to dividend payments of £2.6bn, and share buybacks of £1.5bn.

What about the long term?

I’m confident that BAT will still be a good dividend stock next year, and the year after. But what about in twenty years — when today’s retirement investors might still be dependent on their dividend income, but will be less able to actively manage their portfolios?

I’m not sure — and to be honest, I don’t think anyone else is either. That’s why I wouldn’t recommend BAT as an annuity alternative. In my opinion, there are far better choices in today’s market.

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Roland does not own shares in any of the companies mentioned in this article.