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One of the strongest income returns in my portfolio is british american tobacco (LSE: BATS). Its dividend has increased annually for more than two decades. Currently, the shares are yielding 7.1%.
But past performance is not a guide to what will happen. No dividend is ever guaranteed: how safe is the payment of the manufacturer of dunhill Y Kent cigarettes?
Decreased demand in the long run
Demand for cigarettes remains huge, with British American alone on track to sell more than half a trillions sticks this year.
But the long-term outlook is one of sustained decline. The proportion of the UK adult population that smokes, for example, has fallen by about two-thirds since the 1970s. Clearly, that trend, seen in much of the developed world, is a critical risk for British American Tobacco and your dividend.
However, at least for the medium-term future, I think the company can manage the risk without affecting its payout. Demand is falling, but it’s still huge. The company’s portfolio of premium brands gives it pricing power, which means earnings could hold up better than revenue.
The firm has also been strengthening its position through the development of non-cigarette product lines and the acquisition of competitors, notably with the 2017 acquisition of US rival RJ Reynolds.
Debt and cash flows
Acquisitions can add volume and revenue, but they cost money.
That helps explain British American Tobacco’s inflated balance sheet. Adjusted net debt at the half year stage was £40bn. Service that is expensive. The company’s net financial costs last year exceeded £1.6bn. He noted that this was driven by rising interest rates and a strong dollar. I think both factors could continue to affect British American Tobacco’s cost of debt service.
In its most recently reported full year (2021), the business generated £9.7bn in cash flows from operating activities. It paid £1.5 billion in interest and £4.9 billion in dividends. Although interest costs were high, the company also undertook a £2 billion share buyback programme. That shows that the business continues to generate surplus cash on a large scale.
Over time, while I expect the company to continue to produce massive free cash flows, rising debt service costs could pose a risk to the dividend.
Could the dividend be cut?
If interest costs grow high enough, would the board reduce the payment? At first I think they could.
Although the company has spoken of “keep growing the dividend”, the rate of increase has slowed markedly in recent years. The most recent annual increase of just 1% was small compared to growth rates seen a few years earlier.
But management clearly understands that the British American Tobacco dividend is important to shareholders like me. As the CEO told analysts last year: “Dividend first. (The) dividend will continue to grow.”
The company is targeting a pay rate of approximately 65% of earnings per share. But that’s just one goal. Management has discretion to recommend the dividend. It is committed to continued growth, and the business continues to generate sufficient free cash to support that focus.
No payment to shareholders is perfectly safe. But my confidence in the continued security of the British American Tobacco dividend is a key reason I own the shares and plan to hold them.
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