The FTSE 100 is home to many stocks offering impressive dividend yields in 2023. And among the most generous right now is British American Tobacco (LSE:BATS).
The transitioning cigarette business may not be aligned with every investor’s moral compass. But there’s no denying it’s been a tremendous source of passive income for years, hiking its shareholder payout for more than a quarter of a century.
Having said that, dividend performance may be strong, but the same can’t be said about the stock price. In fact, shares are down over 20% in the last 12 months. And zooming out further reveals the market-cap has been shrinking since 2017, falling by over 50%!
Am I looking at a screaming bargain? Or is there a reason to be fearful? Let’s investigate.
Pressure from regulators
Downward share price momentum can be a sign of financial weakness. But in the case of this business, that doesn’t appear to be what’s happening. In fact, even with the steady decay of cigarette demand, triggered by increased health awareness, management has largely offset the impact through price hikes.
Instead, it seems investors are most concerned about external factors. Regulations surrounding cigarettes are getting increasingly strict. Limits surrounding levels of nicotine consistently becoming tighter, and the UK government has just proposed a new plan to raise the legal smoking age every year.
That’s why British American Tobacco has been investing heavily in alternative products such as vapes, heated tobacco, and oral. This transition still has a long way to go. But the initial results are encouraging, with these products on track to contribute £5bn in sales by 2025.
However, it seems even these aren’t immune to the hammer of regulators, with the European Union banning the sale of flavoured, heated tobacco products.
With an unclear regulatory environment moving forward and an increased focus on ESG factors from investors, it’s easy to understand why this FTSE stock has fallen out of fashion.
Be greedy when others are fearful?
Despite the regulatory headwinds, several factors are working in the firm’s favour. For starters, even with the heavy debt load incurred from its acquisition of Reynolds American in 2017, the group doesn’t appear to be overleveraged.
In fact, thanks to free cash flow generation, management has been systematically paying down debt since the deal took place, eliminating around £4.4bn from the balance sheet.
At the same time, the group’s cash balance continues to rise, along with share buyback programmes and, of course, dividends. However, it’s worth mentioning that interest expenses in its latest results did surge by 14.6% over the first six months of 2023.
That’s hardly surprising, given all the interest rate hikes by the Bank of England to fight inflation. However, it does potentially create additional pressure for management to redirect funds towards paying down its loans faster versus growing dividends.
Nevertheless, management recently reaffirmed its commitment to hold the payout ratio at 65%.
So at the end of the day, is now the time to invest in this business? Personally, it doesn’t tickle my fancy.
I feel British American Tobacco can sustain its impressive dividend yield. But there are a lot of unknown external factors that might change this overnight, adding a lot of risk surrounding an investment.
Therefore, I’m looking elsewhere for income opportunities.
