As they near and enter retirement, many investors shift toward a dividend-focused investment strategy. That's a solid plan, but there's a risk that trying to generate the largest passive income stream leads to a risky portfolio.
That's the dilemma when you consider buying British American Tobacco(NYSE: BTI) and its lofty 8.4% dividend yield. Here's what you need to know about this stock before you add it to your dividend portfolio.
British American Tobacco's big draw is the big dividend yield
If you are looking at British American Tobacco, there's a good chance that you stumbled upon the stock because of its hefty 8.4% yield. On an absolute level, that's a pretty big number, but it becomes even more impressive when you consider it relative to other yields. For example, the S&P 500 (SNPINDEX: ^GSPC) has a skinny 1.2% yield, and the average consumer staples stock, using Consumer Staples Select Sector SPDR ETF(NYSEMKT: XLP) as a proxy, has a yield of 2.6%.
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From this perspective, British American Tobacco looks like a stock that could set you up with a huge income stream. But the big question is, can you actually rely on that income stream for the rest of your life?
The yield alone, while impressive, simply can't tell you that. You need to dig deeper into the company's business to assess whether it can keep paying you that big dividend, year in and year out. This is where the problems begin for British American Tobacco and why its dividend yield is so high.
British American Tobacco is a tobacco company. Its main business is selling cigarettes. Smoking cigarettes has been going out of style across the world, as the health risks it poses have led consumers to avoid the habit and governments to work toward dissuading consumers from smoking (with actions like high tax rates and legally required warnings on packages). The high yield on offer from British American Tobacco is a sign that Wall Street is worried that the dividend may not be sustainable over the long term.
How bad is the dividend risk at British American Tobacco?
Right now, British American Tobacco is covering its dividend (when you take out one-time charges in 2023), so there's probably very little near-term risk of a dividend cut. The nature of cigarettes is such that customers tend to be pretty loyal, which has allowed the company to raise prices on a regular basis. That has helped to offset the negative impact of declining volumes. But you can't ignore the volume declines.
In the first half of 2024, the company's combustibles group, which is largely cigarettes, suffered a 6.9% volume decline. In 2023, the decline was 5.5%. And in 2022, the drop was 5.2%. If any other consumer staples company saw a trend like that, you probably wouldn't buy it.
In fact, in 2023, British American Tobacco made a very troubling accounting change with regard to its U.S. business. It is a complicated shift, but effectively, the company admitted that the business could be worthless in 30 years.
That move resulted in a big one-time charge, but, to be fair, 30 years is a long time. Given the noted volume trends, however, you have to wonder how long this business can support the dividend if even the company expects the volume declines to end at zero. At some point, price increases seem likely to accelerate the decline rather than offset it.
British American Tobacco isn't sitting still
At the end of the day, British American Tobacco is no different from its competition in what is happening to its business. And, like its competitors, it is trying to use the profits it is generating today from cigarettes to invest in new businesses that it hopes will offset the ongoing volume declines it is facing.
To that end, the company has been investing in things like vaping and pouches. It has been having some success. However, the combustibles division still generates four times the revenue of the noncombustibles business.
In other words, there's still a long way to go before British American Tobacco has found a replacement for its slowly deteriorating cigarette operations. If you are hoping that British American Tobacco can set you up with an income stream for the rest of your life, well, that's probably not something you should count on, given the state of the company's most important business.
Should you invest $1,000 in British American Tobacco right now?
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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends British American Tobacco P.l.c. and recommends the following options: long January 2026 $40 calls on British American Tobacco and short January 2026 $40 puts on British American Tobacco. The Motley Fool has a disclosure policy.
