Will Collapsing Cigarette Demand Crush British American Tobacco plc’s Dividends?

Today I am looking at why British American Tobacco (LSE: BATS) (NYSE: BTI.US) could be considered a risky income selection.smoking

Dividend growth set to stumble

Naturally, the tobacco sector has long been a happy hunting ground for those seeking steady dividend growth. The addictive nature of cigarette consumption means that the likes of British American Tobacco have enjoyed tremendous revenues streams, and with it earnings expansion, allowing it to build the full-year payment at a compound annual growth rate of 9.4% since 2009 alone.

But the smoking industry has been smacked by a flurry of issues in recent years. Legislators are stepping up the fight against ‘big tobacco’ with a variety of measures, from traditional smoking bans and plain packaging through tobacco excise hikes in key markets. Meanwhile, a natural tailing off in consumer interest due to health concerns, as well as the effect of reduced spending power, is also hampering the profits prospects of the world’s largest ‘tab’ manufacturers.

As a result, British American Tobacco is anticipated to experience its first earnings fall for many years this year, with a 4% fall currently pencilled in by City analysts.

However, current forecasts indicate that the company remains set to maintain its progressive dividend policy, with a 2.7% payment rise predicted this year to 146.2p per share. And an 8% earnings improvement in 2015 is expected to herald a far juicier 6.8% dividend jump to 156.1p.

… and payout projections are less than sturdy

Still, the dividend decelerations expected this year and next indicate the problems which have gradually eroded earnings in recent years. And investors should be aware that projected payouts this year are also insufficiently covered by the bottom line — coverage of 1.4 times earnings through to the close of 2015 falls some way short of the minimum safety yardstick of 2 times.

It is true that British American Tobacco has terrific exposure to the white-hot e-cigarette market through its Vype brand, a segment which is expected to drive long-term growth as off-take of traditional products falls.

But the vast sums required to develop and market this technology in what promises to be a cut-throat marketplace is likely to weigh heavily on the balance sheet. The company is also likely to have to keep on splashing the cash to keep its operations elsewhere afloat through organic investment and acquisitions, such as the $4.7bn forked out to maintain its 42% stake in Reynolds American in the summer.

Indeed, the effect of lower operating profit and higher capex flows saw British American Tobacco’s free cash flow topple by 30% during January-June to £567m.

Should problems persist at the top line, both earnings and dividend growth at British American Tobacco could be exposed to heavy weather in coming years.

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Royston Wild has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.