Is the 7%+ British American Tobacco dividend yield safe?

One of the solid income players in my portfolio is British American Tobacco (LSE: BATS). Dividends have increased every year for more than two decades. Currently, the stock is yielding 7.1%.

But past performance is no guide to what will happen. There is no guaranteed dividend – how safe is the payment from the producer Dunhill and Kent cigarettes?

A long-term decline in demand

Demand for cigarettes remains high, with British Americans only able to sell more than half a trillion stick this year.

But the long-term picture is one of steady decline. The proportion of the UK adult population who smoke, for example, has fallen by around two-thirds since the 1970s. It is clear that this trend, seen in many developed countries, is a critical risk for British American Tobacco and its dividends.

However, for the medium-term future, I think the company can manage the risk without affecting the payout. Demand is down but still great. The company’s portfolio of premium brands gives it pricing power, meaning profits can be better than profits.

The company has also strengthened its position by expanding its non-tobacco product line and acquiring competitors, notably with the 2017 takeover of American rival RJ Reynolds.

Debt and cash flow

Acquisitions can increase volume and profits – but they cost money.

That helps explain the bloated balance sheet at British American Tobacco. Adjusted net debt at the half-year stage was £40bn. Expensive service. The company’s net finance costs last year were more than £1.6bn. It noted that this was driven by rising interest rates and a strong dollar. I think two factors can continue to affect debt service costs for British American Tobacco.

In the most recently reported full year (2021), the business generated £9.7bn of cash flow from operating activities. It paid out £1.5bn in interest and £4.9bn in dividends. Despite the huge interest costs, the company is also undertaking a £2bn share buyback programme. Which demonstrates the business continues to generate excess cash on a large scale.

Longer term, although I expect the company to continue to generate substantial free cash flow, rising debt service costs could put the dividend at risk.

Can dividends be deducted?

If interest costs grow large enough, will the Board reduce the payment? In principle, I think they can.

Although the company has talked about “continue to increase dividends“, the rate of increase has been very slow in recent years. The most recent annual increase is only a small 1% compared to the growth rate seen a few years ago.

But management clearly knows that British American Tobacco’s dividend is important to shareholders like me. As the chief executive told analysts last year: “Dividends first. [The] dividends will continue to grow.”

The company targets a payout ratio of approximately 65% ​​of earnings per share. But that’s just the target. Management has discretion to recommend dividends. It is committed to continued growth and the business continues to generate enough free cash to support that approach.

No shareholder payout is ever safe. But my belief in the safety of British American Tobacco’s dividend is the main reason I own the stock – and plan to keep it.