If you are looking for blue-chip income, one of the best companies I believe you can buy for your portfolio right now is British American Tobacco (LSE: BATS). This company has one of the best dividend track records in the FTSE 100, but over the past 12 months, investors have turned their backs on the business, pushing the shares down to a level not seen since 2011.
As the share price has plunged, British American’s dividend yield has surged and now stands at 7.6%. Compared to the average cash ISA interest rate available at the moment (1.5%), this dividend yield looks too good to pass up.
That said, one of the reasons why investors have been dumping its shares recently is due to concerns that the company could cut its dividend in the near term. Today, I’m going to explain why this is unlikely.
When British American decided to buy out American peer Reynolds several years ago, it seemed like a masterstroke. However, now it’s coming back to haunt the business.
The vast majority of Reynolds’ income comes from menthol cigarettes, which the US food and drug administration has now decided they want to try and ban. This will take some time to bring in, and tobacco companies have said that they will fight it in the courts. But when it does, Reynolds’ new owner might have a problem. Not only will the ban hit profits, but it’ll also impair the group’s ability to repay the vast amount of money it borrowed to fund the deal.
This is why City analysts are starting to become sceptical that British American can maintain its payout. A squeeze on profits could mean the firm has to choose between paying off creditors and paying shareholders.
Personally, I believe these concerns are overblown for three main reasons. Firstly, the ban hasn’t yet come into force and is unlikely to do so for several years. Secondly, when menthol cigarettes are banned, smokers are unlikely to stop smoking altogether, and will most likely switch to a non-menthol brand. Thirdly, British American is a cash flow machine.
In the first half of 2018, the company generated a free cash flow after the payment of dividends of £1.5bn. I estimate the total free cash flow for 2018, after payment of dividends, will be slightly above £3bn. At this rate, the group should be able to pay off around half of its £48bn debt mountain within eight years.
Put simply, it looks to me as if the company has the financial headroom to both maintain its current dividend and reduce debt.
The bottom line
Considering all of the above, I think it’s worth buying British American for income at current levels. A valuation of less than nine times forward earnings only sweetens the appeal, in my opinion, and gives a wide margin of safety for investors buying today.
Rupert Hargreaves owns shares in British American Tobacco. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.