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For dividend-hungry investors looking for high-yield shares, tobacco companies are a perennial favourite.
That makes sense. Cigarettes are cheap to make and can sell for a pretty penny, meaning that tobacco companies can generate a lot of cash.
With the industry in long-term decline, growth opportunities are limited. That means high operating cash flows can often convert into high free cash flows, instead of needing to be ploughed back into the business.
Meanwhile, as some investors shun tobacco shares on ethical grounds, death-stick makers often prioritise their dividend as a key plank of their investment case.
Two London-listed cigarette companies
For example, consider UK-based firms British American Tobacco (LSE: BATS) and Imperial Brands (LSE: IMB).
At the moment, these two FTSE 100 members offer dividend yields of 6.1% and 6.0%. Compared to the FTSE 100 average of 3.3%, that is a potentially lucrative opportunity for investors.
Share price gains
Lately, some of the appeal has been about capital gains, as well as dividends.
Over five years, British American shares have moved up 43%, while the Imperial Brands share price has grown by 130%.
That is impressive stuff, but a couple of caveats are in order. One is that tobacco stocks tend to come in and out of fashion. They have a defensive quality thanks to cigarettes’ addictive qualities (perhaps explaining recent strong performance amid volatile markets).
But ongoing risks such as declining cigarette use and potentially higher regulatory or litigation costs can weigh on them even in a bull market.
Meanwhile, Imperial’s five-year performance is affected by its baseline.
Five years ago, Imperial reversed its policy of 10% annual growth in its annual dividend per share and cut the payout significantly. That sent the share price down sharply.
Both companies’ share prices remain well below where they were in 2016/17.
Looking to the future
While Imperial cut its dividend in 2020, British American has raised its payout per share annually for decades.
It plans to keep doing so. Imperial also has such a plan, or what is known as a progressive dividend policy.
The big question for the industry overall – including Britain’s two sizeable tobacco manufacturers – is how sustainable the current business model is.
Cigarette smoking is falling in most markets and that looks set to continue. Non-cigarette products potentially offer to fill some of the revenue gap, though how much remains to be seen.
So far, products such as vapes have been nowhere near as profitable as cigarettes. That could change over time with product development and economies of scale. Or, it may not.
Milking the cash cow, while building future replacement revenue streams
That question matters because Imperial’s approach has been to milk its cigarette cash cow and move fairly cautiously into other areas, whereas British American has been more full-throttled in building its non-cigarette business.
Imperial’s approach could make sense given the rather unattractive economics of the non-cigarette market for now. In the long term, though, trying to milk a cash cow with declining user numbers has a shelf life as a strategy.
I think British American’s approach sets it up better to move beyond cigarettes, while also benefiting from the long tail of that business. Between these two high-yield shares, I see British American as the one for long-term investors to consider.
