Income? Yes, please! Like a lot of investors, I like the passive income potential offered by owning dividend shares. A popular one among income investors is Pall Mall manufacturer British American Tobacco (LSE: BATS).
The yield – 5.3% — is well above the 3% average offered by the FTSE 100 overall.
That is not the only attraction, though. British American Tobacco has increased its dividend annually for decades.
Now, that is not a guarantee of what might happen in future – though the firm does aim to maintain its approach of annual dividend growth.
But it is indicative of just how cash generative the tobacco industry can be, thanks to an addictive product, low production costs, and potentially high selling costs.
In British American’s case, that is bolstered further by the appeal to smokers of its premium brand portfolio.
Things will likely get progressively harder
However, there are reasons that people might not want to invest in British American.
One is ethical: some people shun shares in tobacco firms.
Even for those who are willing to invest in the sector, another potential reason not to buy into British American is the long-term trajectory of the cigarette market.
Cigarette usage is declining year after year in many major markets. It looks set to keep declining for the foreseeable future.
Because cigarette prices can be increased without turning off many customers, makers can seek to offset declining demand by raising prices.
But even this approach has its limits. British American has seen revenues fall for the past two years in succession, on the back of steep cigarette volume declines. I see both of those trends as likely to continue.
Moving beyond cigarettes
Another strategic approach to try and reduce the impact of declining cigarette demand is to branch into non-cigarette products.
The company has spent a lot of time and money in recent years growing its non-cigarette product range, for example with vapes.
I think that approach could well have some long-term success. But the economics of cigarettes are hard to replicate and it remains to be seen whether vapes, which are more expensive to produce, will ever be anything like as profitable as fags.
I’m upbeat about the dividend prospects
British American has other risks for investors too.
Those strong cash flows I mentioned mean that it has been able to borrow large amounts. It has a sizeable net debt.
While I expect ongoing cash flows to allow the company to service that debt without problems, the associated substantial interest costs nonetheless eat into profitability.
However, the reality is that cigarette use has already been declining for a long time. British American has proven resilient and adaptable thus far. I expect that to remain the case.
Even though cigarette use is in sharp decline, it remains substantial. Indeed, the company sells billions of cigarettes per week. I see the British American investment case as relying on the income potential, so the board is highly motivated to keep growing the payout.
At some point it may become unsustainable. For now, though, the company can afford it — and personally I expect it to last. I see this as a dividend share for investors to consider.
Should you invest £5,000 in British American Tobacco P.l.c. right now?
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Christopher Ruane does not hold any position in the companies mentioned.
