In today’s uncertain economic climate, dividend stocks can be a tempting haven for investors seeking steady passive income. One such company that tends to catch the eye is British American Tobacco (LSE: BATS), currently boasting a whopping 9.4% dividend yield. But is this tobacco titan a hidden gem or a value trap? Let’s dive in and take a closer look.
A giant of the market
The company is a global powerhouse in the tobacco and nicotine industry. With a market cap of £55.5bn and a portfolio of iconic brands including Dunhill, Lucky Strike, and Vuse, it has a formidable presence in over 180 markets worldwide.
The company’s size and scale provide it with significant advantages, including strong pricing power and economies of scale. These factors have historically contributed to its ability to generate substantial cash flows and maintain its generous dividend payouts.
Despite this strength, the shares have been fairly sluggish in 2024, with only a 7% increase compared to the wider UK market at 6.9%.
An appealing dividend
The current 9.4% dividend yield is certainly eye-catching. The company has a track record of consistent dividend payments, with its next dividend of £0.59 per share scheduled for August 2.
However, I feel like passive income-focused investors should approach with caution. The company’s payout ratio currently stands at a concerning -36%, indicating that the firm is paying out more in dividends than it’s earning. This situation isn’t sustainable in the long term and could lead to dividend cuts if profitability doesn’t improve.
Risks ahead
At first glance, the firm appears to be trading at a healthy discount. The stock is currently priced 52.4% below a discounted cash flow (DCF) estimate of its fair value, suggesting it could be undervalued.
Analysts also expect earnings to increase by an impressive 51% annually for the next few years. However, I feel that it’s crucial to consider the challenges facing the tobacco industry, including declining smoking rates in developed markets and increasing regulatory pressures worldwide.
While the firm is diversifying into next-generation products like e-cigarettes and heated tobacco, these segments still represent a small portion of overall revenues. The company’s high debt levels (with a debt-to-equity ratio of 74.5%) could also limit its financial flexibility in navigating industry challenges.
Moreover, it reported a significant loss in its most recent earnings report, with earnings per share (EPS) of -£6.51. I suspect this poor performance explains the negative payout ratio and raises serious questions about the company’s ability to maintain its dividend at current levels.
What’s next?
British American Tobacco presents a complex investment case. Its high yield and apparent undervaluation clearly make it an intriguing option for investors looking for passive income. However, the sustainability of its dividend, industry challenges, and recent financial performance are significant concerns that shouldn’t be overlooked. I don’t want to take that risk, so I’ll be putting my money to work elsewhere.
This post was originally published on Motley Fool
