In some respects, British American Tobacco (LSE:BATS) could possibly be thought of the proper passive revenue inventory.

It’s presently (30 August) yielding 8.3%, properly above the common for the FTSE 100 of three.8%.

And for 1 / 4 of a century, it’s elevated its payout year-on-year. This implies it qualifies as a Dividend Aristocrat.

Nevertheless, regardless of being a cultured inventory, I wouldn’t contact it with a bargepole.

Let me clarify.

A money machine

British American Tobacco has been in a position to pay beneficiant dividends due to its capability to generate lots of money. Promoting a cheap-to-make, highly-addictive product is a technique of making certain a wholesome financial institution steadiness and powerful money flows.

To assist issues additional, conventional cigarettes are simple to fabricate and the fundamental design hasn’t modified for many years. This implies there’s by no means been a have to put aside vital quantities of money for product innovation. 

Till now.

A special future

The tobacco trade is in transition.

As conventional cigarettes fall out of vogue, corporations are putting a better emphasis on vapes and different so-called decreased threat merchandise (RRPs). British American Tobacco envisages a smokeless world with 50% of its income coming from RRPs, by 2035.

However this requires vital funding. These New Class merchandise are costlier to make and are more likely to require continuous innovation and growth to maintain them related.

And there’s an extended solution to go earlier than they replicate the monetary success of cigarettes. For the six months to 30 June 2024, the smokeless vary contributed 17.6% of income however solely 2.3% of working revenue.

For that reason, I believe BAT’s standing as a Dividend Aristocrat just isn’t going to final. Having mentioned that, the decline in conventional cigarette gross sales will likely be gradual so I don’t assume there’s any imminent risk to the payout.  

However there are growing issues in regards to the security of RRPs. The World Well being Group says that vapes at the moment are banned in 34 nations, together with India and Brazil.

These restrictions may result in elevated income from non-combustible merchandise failing to compensate for the lack of revenue on account of declining conventional gross sales. If this occurs, I’d be very assured that each the corporate’s share price and dividend will fall.

And naturally, many moral traders don’t need something to do with the trade. This implies there’s an estimated 20% of funds that can by no means spend money on the corporate.

Good worth?

If I didn’t have these issues, I’d be tempted by the low valuation of the inventory.

For the yr ending 31 December 2024, analysts are forecasting earnings per share of 359.7p. This means a ahead price-to-earnings ratio of seven.9. That’s low-cost for a FTSE 100 inventory that’s yielding greater than twice the index common.

And that is in keeping with its closest rival.

Imperial Manufacturers, the opposite tobacco firm within the Footsie, is presently buying and selling on a ahead earnings a number of of seven.3.

Its yield is 7.2%.

This tells me that different traders have related issues in regards to the long-term viability of the trade.

Shareholders are demanding beneficiant ranges of passive revenue to compensate for the perceived extra threat related to having these shares of their portfolios.

Even with a yield of 8.3%, I’m not tempted to spend money on British American Tobacco. It’s simply too dangerous for me.

I feel my cash would go up in smoke.