British American Tobacco is doing a good job shifting away from cigarettes, but there’s another risk investors need to watch.
British American Tobacco (BTI 2.27%) has a huge 9.7% dividend yield. Given the roughly 1.3% yield on offer from the broader market, the ultra-high yield is a clear sign of increased risk. That’s not shocking, given that the company’s main product is facing a secular decline. But there’s more to worry about here than just cigarettes.
British American Tobacco is doing reasonably well
There’s no way to sugarcoat what’s going on with British American Tobacco’s business. In 2018, it produced roughly 700 billion cigarettes. By 2023, it was producing just 555 billion. That’s a huge 21% volume decline in about five years. It has been able to offset the revenue hit from that drop by raising prices, but something is clearly wrong with the company’s core tobacco business.
To be fair, British American Tobacco is not alone. Its main rivals, Altria (MO 0.64%) and Philip Morris International (PM -0.19%), are both facing the same headwind and taking the same approach to dealing with it. However, at some point, price increases are likely to make the volume decline worse. When that happens, all three of these tobacco giants could be in for some severe pain.
That’s why all three are looking to use tobacco profits to invest in other nicotine-related operations. British American Tobacco has been doing fairly well on that front. In 2023, its new categories businesses, basically the non-cigarette operations, made up 16.5% of revenue and, more importantly, was profitable at the division level. It achieved profitability two years ahead of management’s plan, so this is a big deal.
By comparison, Altria has made a number of bad decisions that have led to massive one-time charges. Philip Morris International, however, has been doing fairly well diversifying its business, with smoke-free products accounting for 39% of revenues in the first quarter of 2024. So, British American Tobacco falls kind of in the middle when it comes to dealing with the decline of the cigarette business.
That said, Altria’s dividend yield is 8.6%, and Philip Morris International’s yield is just 5.2%. From a risk/reward standpoint, British American Tobacco’s 9.7% yield seems like it might be pretty compelling.
There’s one more risk to consider
Before running out and buying British American Tobacco’s high yield, however, you’ll want to consider one more factor: the company’s balance sheet. At the end of 2023 — the foreign-based company reports financials only twice a year — its debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio was roughly 4.7. That compares with 3.6 for Philip Morris International and 2.2 for Altria.
BTI Financial Debt to EBITDA (TTM) data by YCharts. EBITDA = earnings before interest, taxes, depreciation, and amortization. TTM = trailing 12 months.
Given the headwinds facing the tobacco business, financial strength should be just as important to investors as the business’s operating results. And, in this case, British American Tobacco looks to be the weakest of the main players. That’s not to suggest that there is any imminent risk, per se, but that, at least right now, it seems British American Tobacco’s peers are better positioned to deal with adversity.
Watch this factor closely
From a risk/reward standpoint, British American Tobacco will probably be attractive to more aggressive investors. It’s holding its own in the cigarette space and doing better than planned in its effort to diversify its operations. But investors who decide to buy the stock need to pay attention to more than just the operating results because having a more heavily leveraged balance sheet could end up being a very big negative should the cigarette industry reach a tipping point.
While leverage is yet another reason for conservative investors to avoid British American Tobacco, cigarettes being the No. 1 reason, it probably shouldn’t keep more aggressive investors away. However, more aggressive investors should still be closely monitoring the debt situation here.
Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool recommends British American Tobacco P.l.c. and Philip Morris International 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.