One of the most solid income performers in my portfolio is British American Tobacco (LSE: BATS) — its dividend has risen annually for more than two decades. Currently, the shares yield 7.1%.
But past performance is not a guide to what will happen. No dividend is ever guaranteed – how safe is the payout from the maker of Dunhill and Kent cigarettes?
Long-term demand decline
Cigarette demand remains vast, with British American alone on course to sell well over half a trillion sticks this year.
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But the long-term picture is one of sustained decline. The proportion of the UK adult population that smokes, for example, has fallen by roughly two thirds since the 1970s. Clearly that trend, seen in much of the developed world, is a critical risk for British American Tobacco and its dividend.
However, for the medium-term future at least, I think the company can manage the risk without affecting its payout. Demand is falling but remains huge. The company’s premium brand portfolio gives it pricing power, meaning profits might hold up better than revenues.
The firm has also been bolstering its position through developing non-cigarette product lines and acquiring competitors, notably with the 2017 takeover of American rival R J Reynolds.
Debt and cash flows
Acquisitions can add volume and revenues – but they cost money.
That helps explain the bloated balance sheet at British American Tobacco. Adjusted net debt at the half-year stage was £40bn. Servicing that is expensive. The company’s net finance costs last year were above £1.6bn. It noted this was driven by rising interest rates and a strong dollar. I think both factors could continue to affect the cost of debt servicing for British American Tobacco.
In its most recently reported full year (2021), the business generated £9.7bn in cash flows from operating activities. It paid out £1.5bn in interest and £4.9bn in dividends. Although interest costs were large, the company also undertook a £2bn share buyback programme. That demonstrates the business continues to generate surplus cash on a big scale.
Over time, although I expect the company to continue producing massive free cash flows, growing debt servicing costs could pose a risk to the dividend.
Could the dividend be cut?
If interest costs grow big enough, would the board reduce the payout? In principle I think they could.
Although the company has talked of “continuing to grow the dividend”, the rate of increase has slowed markedly in recent years. The most recent annual increase of just 1% was small compared to the growth rates that were seen a few years before.
But management clearly understands that the British American Tobacco dividend is important to shareholders like me. As the chief executive told analysts last year: “Dividend first. [The] dividend will continue to grow.”
The company targets a payout ratio of approximately 65% of earnings per share. But that is only a target. Management has discretion in recommending the dividend. It is committed to continued growth and the business continues to generate enough free cash to support that approach.
No shareholder payout is ever perfectly safe. But my confidence in the ongoing safety of the British American Tobacco dividend is a key reason I own the shares – and plan to keep them.
