In the UK, few income stocks are as popular as Lloyds or Legal & General right now. Both financial institutions offer impressive dividend yields that far exceed the FTSE 100’s 3.2% today. In fact, Legal & General shares are sitting on a staggering 9.1% payout.
However, with interest rates now steadily declining and uncertainty brewing in the financial markets, institutional analysts are growing a bit more cautious surrounding these popular stocks. And instead, more attention’s being given to another FTSE 100 stalwart – British American Tobacco (LSE:BATS).
In mid-September, the analyst team at UBS issued a Buy recommendation for the tobacco giant with a share price target of 5,200p. That’s around 37% higher than where the stock’s trading today. And when combining this with the current 6.3% dividend yield, there seems to be some impressive investment return potential on offer right now.
By comparison, the average consensus forecasts for Lloyds and Legal & General sit at just 15% and 8.4% respectively. So what’s behind this aggressive projection? And should investors be rushing to buy British American Tobacco shares right now?
Key growth drivers
UBS’s thesis revolves around the group’s next-generation nicotine products. Its Vuse and Velo brands have both shown encouraging progress in terms of market penetration, particularly in key markets like the US.
At the same time, its soon-to-be legacy combustible tobacco business continues to generate robust cash flows supporting the high dividend yield. As such, the group’s latest half-year results left many investors impressed, with full-year guidance reiterated and revenue growth expected to land towards the higher end of the range.
Dividends were subsequently hiked, continuing the group’s 25+ year history of consecutive payout increases. And a further £200m was added to the group’s share buyback budget for 2025, bringing the total to £1.1bn.
With British American Tobacco shares seemingly oozing cash to shareholders, it’s not surprising that the stock and investor sentiment are both on the rise.
What to watch
Even with an optimistic outlook, UBS still highlights several weak spots for investors to monitor carefully. Regulatory intensification surrounding tobacco products continues to ramp up – not just for cigarettes but for nicotine pouches as well.
We’ve already seen regulatory pressure adversely impact traditional cigarette sales. And with consumer health consciousness rising, the clock’s undeniably ticking for the company to make its transition away from traditional cigarettes.
On the operational front, the business is currently doing a bit of restructuring and digitalisation to help protect profit margins. If everything goes according to plan, these self-help efforts could yield £500m in annualised savings by the end of 2028.
That’s definitely good news for dividends and free cash flow, but it also comes attached with some execution risk.
The bottom line
All things considered, I can see why analysts are growing a bit more bullish. And while owning shares in a tobacco company hardly lines up with more ESG-focused investors, those happy to own sin stocks may want to consider taking a closer look.
