Can British American Tobacco Shares Really Provide a Long-Term Second Income?

Shares in British American Tobacco (London Stock Exchange: Bats) currently comes with more dividend yield. This should attract the attention of investors looking for a second income.

However, the big question is durability. Tobacco production volumes are declining, so the question is whether the company’s next generation of products can compensate for this weakness.

Dividend Cover

I don’t often look at dividend cover – the difference between a company’s earnings and its dividends – as a useful metric. Mainly because it is easy for investors to draw the wrong conclusion from this.

However, British American Tobacco is one of the rare cases where I find this useful. Over the past 10 years, the firm has distributed most of its earnings to shareholders. This means there isn’t much room to maneuver. If earnings start to fall, the company may not be able to maintain its dividend for long.

Cigarette smoking rates are slowly declining, but I expect this process to accelerate over time. Thus, the firm will have to replace this income in order to continue sending money to investors.

New generation products

In fact, it looks like these will be British Tobacco’s new category of products to hit the market. These include vapes, nicotine pouches and heated tobacco.

There is evidence of strong growth in this part of the business. New product revenue has grown 33% annually since 2020 and the division now accounts for nearly 20% of total sales.

The division also recently became profitable. So, if the strong momentum continues, investors could enjoy a second income for a long time to come.

There is another important point to consider. If the company’s new products look like they will be able to maintain the dividend, I wouldn’t expect the yield to remain at 8%.

Consumer goods

Right now, marketclearly thinks of British American Tobacco as a declining tobacco business. And this is quite fair – this is where about 85% of income comes from.

However, if the company starts to look like a more stable consumer products business, I expect that to change. Similar Unilever And Chaleon do not have a dividend yield of 8%.

Their dividend yield is less than half that amount because long-term demand for their core products is more resilient. And expect British American Tobacco to do the same if its business follows a similar path.

This means the share price could double if smoke-free products are eventually able to fully support the current dividend. It’s a big ask, but also a huge potential reward if it’s possible.

Safety margin

The case for British American Tobacco stock comes down to whether smoke-free products can replace enough lost cigarette revenue to justify the share price. I think it’s too close to call.

From here it won’t take me long to get across the line. So I’ll be keeping a very close eye on the December update for news on new category growth.