British American Tobacco (LSE:BATS) shares have had a pretty rough year. The price has fallen by 19%. This is pretty dismal considering that the Footsie is up by over 4% in the same period. However, I believe this provides me with a great opportunity to generate strong passive income.
The income opportunity
Most people will see a 19% fall in share price and think this is very bad news.
Income investors like me will scent an opportunity. The cost to obtain the future stream of dividends is now 19% cheaper than before. It’s important to bear in mind that dividends aren’t guaranteed, however.
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British American Tobacco shares are now trading for £23.99 apiece, providing a mouthwatering dividend yield of 10.1%.
Therefore, if I spent £42,798.16 to buy 1,784 of its shares, I could generate an extra £350 a month. That said, I appreciate that this isn’t a trivial amount of money, and I wouldn’t want to unbalance my portfolio.
The company has a strong track record of raising dividends too. It’s among the Dividend Aristocrats, which is a company that’s raised its dividend for at least 25 consecutive years. Therefore, there’s a strong likelihood that my extra £350 a month will increase over time.
Moreover, if I decided to reinvest all or part of the extra amount generated back into the stock, I’d make even more.
Long term challenges
It must be said that there are some serious concerns with British American Tobacco’s business model.
Firstly, with smoking in decline, it’s difficult to see a long-term future for traditional tobacco products. The number of regular adult smokers has fallen sharply from 45.6% in 1974 to 11.2% in 2022.
Secondly, the UK government proposed a new law last year where no one under the age of 15 will ever be able to buy a cigarette legally. As a result, the company itself has said the long-term value of its key brands is zero.
However, all is not doom and gloom.
It’s been able to offset the falling demand with significantly higher cigarette prices over time, so although volumes are declining, revenue in 2023 increased 3.1% from 2022.
Additionally, smoking remains a huge market. British American Tobacco is expecting to continue growing free cash flow over the next five years. £40bn is expected to be generated in that period, which should allow the company to keep growing its dividend.
A defensive stock
The tobacco industry will eventually be extinguished, but this won’t be for a few decades.
Furthermore, the company is preparing for a smokeless world. For example, it now also sells vapes and nicotine patches. Some 24 markets now have smokeless revenue greater than 30% of overall revenue. For the first time, this segment has become profitable in 2023.
I want to finish off by pointing out that British American Tobacco is a fairly recession-resistant company. An unfortunate reality is that people are addicted to smoking. However, it means that during times of economic turmoil, the company isn’t affected so badly. This is something I value when looking for a business to pay me a reliable dividend over time.
The stock is trading at a very cheap valuation, with a forward price-to-earnings ratio of just 6.5. Therefore, if I had the spare cash, now would be a great time to buy some of its shares.
