There are a lot of things that one must consider
prior to buying stock in a publicly-traded company. Some of these
things include the strength of a company's business model,
geographic diversification, financial condition, valuation, and
Another important concern is the dividend that the
company in question pays out. Strength and sustainability of the
dividend are very important for dividend growth investors. In fact,
did you know that 42% of the total return of the S&P 500 over the
last 80+ years came from dividends? This is why dividends are so
important for any investment portfolio.
Today, let's dig into the tobacco sector and
check out the dividends from Altria, Reynolds American, and
Lorillard. These are the three biggest domestic tobacco players. We will
look into the dividend history of each company, its historical
dividend growth rates, whether or not each company's dividend is
supported by cash flows, and whether the companies can sustain their
dividend growth rates in the future.
When talking about a
company's dividend, the first thing that normally comes to mind is
the dividend yield, which is the percentage of your capital that you
receive in return over the next 12 months, as long as the dividend
amount is not changed. Here are the dividend yields from Altria,
Reynolds American, and Lorillard.
Table 1: Dividend Yields Of Altria, Reynolds
American, and Lorillard
Note that these dividend yields are forward yields,
and include the recently-announced dividend increases from Reynolds
American and Lorillard. When it comes to who has the strongest
dividend yield, it's a tie between Altria and Reynolds American.
The dividend yield is just one of many factors that
need to be considered when it comes to the strength of a company's
dividend. A company's stock can have a high dividend yield due to an
unsustainable dividend payout ratio, or poor fundamentals that have
brought down the stock price. These items could then lead to a
dividend cut, which will reduce your yield on cost.
Dividend growth should also be considered. This is
because a company that increases its dividend payout every year
maintains the purchasing power of the income streams that are
received by its investors. If dividend growth rates can't keep up
with inflation, then investors are really losing money when they
consider the loss in purchasing power. Dividend increases also
signal a strong outlook by management and underscores their
commitment to shareholders. Many companies regard their dividends as
a sacred cow. Over time, dividend growth can supercharge an
investor's yield on cost. Consider Warren Buffett, who started
buying Coca-Cola back in the '80s. Now, he receives a yield on cost
of 40%, and growing every year as long as Coca-Cola keeps increasing
their payout. Sounds like a pretty good deal, no?
Let's see how the dividends of Altria, Reynolds
American, and Lorillard have grown over the last 5 years. The numbers in the table
represent the average dividend growth rate over the last five years.
Table 2: Five-Year Dividend Growth Rates Of Altria,
Reynolds American, and Lorillard
All three of these companies have shown outstanding
dividend growth rates over the last five years, easily outpacing the
erosive effects of inflation. However, Lorillard comes out
on top here with an average annual growth rate of 14.1%, well above
the dividend growth rates of Altria and Reynolds American. Altria
has increased its dividend 47 times in the last 44 years. Of course,
Altria owned Philip Morris International and Kraft Foods during a
lot of that time. These two companies were spun off from Altria in
2008. Reynolds American increased its dividend 7 times since 2009.
Lorillard has increased its dividend every year since being spun off
from Loews Corp. in 2008.
These strong dividend histories could not have happened
without each company's exceptionally strong business models and
brand strength. For right now, Lorillard is the winner, when
looking at dividend growth over the last five years.
Dividend Payout Ratio
High dividend yields and strong growth rates are all
well and good, but we need to make sure that the company in question
is making enough money to keep the dividends going. This is where
the dividend payout ratio comes in. The payout ratio is the
percentage of the company's profits that get returned to
shareholders in the form of dividends. You usually like to see this
ratio at 60% or below, as that will insure that the dividends will
continue to get paid, even if the company experiences a downturn
over a short period. Dividend payout ratios that approach or exceed
100% may signal future dividend freezes or cuts, which are not good
at all for investors.
The table below shows the dividend payout ratios for
Altria, Reynolds American, and Lorillard, both on a trailing twelve month and a
four-year average basis. The earnings that I used in these
calculations are referred to as core earnings, which remove one-time
items that don't have an impact on the company's operations.
Table 3: Dividend Payout Ratios of Altria, Reynolds
American, and Lorillard
From the looks of Table 3, the dividend payments of
Altria, Reynolds American, and Lorillard are all relatively high in
absolute terms. However, the current payout
ratios are inline with the four-year averages. It should also be
said that tobacco companies generally have higher payout ratios due
to not having to constantly innovate and invest in new equipment and
technologies. The cigarette business is pretty simple in that
Altria targets a payout ratio of 80% of core
earnings, while Lorillard targets a payout ratio that's between 70%
and 75% of earnings. Reynolds American targets a payout of 80% of
How About That Free Cash Flow?
A lot of folks would end their analysis after
calculating the dividend payout ratio. However, we need to keep in
mind that that figure is based on dividend payout as a percentage of
earnings, not actual cash that comes into the business over a
certain period of time. Earnings often contain items like
depreciation, asset impairments, actuarial gains on pension plans,
and other non-cash items that can distort the picture as to how
healthy a company's dividend really is. For this reason, I like to
calculate the free cash flow payout ratio, which shows us what
percentage of cash that comes in over a 12-month period gets
distributed to shareholders. This paints a more accurate picture
when it comes to the dividend safety of the company in question.
Table 4 shows the percentages of free cash flow that
were paid out in dividends for our three companies. Note that free
cash flow is calculated as operating cash flow, subtracted by
capital expenditures. Trailing 12-month and four-year average
figures are shown.
Table 4: Free Cash Flow Payout Ratios Of Altria,
Reynolds American, And Lorillard
Here, we see that both Altria and Reynolds American
are paying out extremely high percentages of their free cash flows
in dividends. This means that any future dividend growth will have
to come from increases in free cash flow, unless the company decides
to borrow money to fund higher dividends. Right now, Reynolds
American is using all of its free cash flow to pay out dividends.
Lorillard has the lowest payout ratio of the three.
It will be interesting to see how this figure changes with the
company's recently-announced 12% dividend increase.
When it comes to the free cash flow payout ratio,
Lorillard is the winner here.
Any Ways To Predict Dividends Going Forward?
A lot of folks would end their analysis here,
especially after looking at the free cash flow payout ratios.
However, these figures are all based on what happened in the past.
We need to find some clues as to whether the company can continue
paying steadily increasing dividends in the future.
Interest Coverage Ratio
The interest coverage ratio illustrates the size of
the company's pre-tax profits relative to the company's interest
payments. Generally speaking, the more debt a company has, the more
interest it has to pay, and the less that the company has left over
to pay out dividends. The interest coverage ratio is calculated by
dividing the company's earnings before interest and taxes (EBIT) by
the company's interest payments made over the same period of time.
Low interest coverage ratios (usually below 2) generally show that
the company is having a hard time just trying to make its interest
payments. That may signal dividend cuts or eliminations in the
future. For this reason, we like to see high interest coverage
Table 5 shows the interest coverage ratios of Altria,
Reynolds American, and Lorillard over the last 12 months.
Table 5: Interest Coverage Ratios of Altria, Reynolds
American, and Lorillard
Table 5 shows us that while Altria was able
to cover its interest obligations almost 8 times last year,
Reynolds American and Lorillard were able to cover their interest
obligations more than 11 times with pre-tax earnings.
Net Debt To Equity Ratio
The amount of debt that a company has can ultimately
influence the future direction of the company's dividend. Companies
that have more debt typically pay more in interest. It should also
be noted that at some point, the company's debt will need to be
repaid. While many companies are working around this by refinancing
the debt at low interest rates, this option might not be as
attractive when interest rates head back up. When the company
finally does extinguish its debt, it may have an adverse effect on
whether it can continue paying dividends.
The net debt to equity ratio can offer us some clues
as to how much of a problem debt will be when it comes to paying out
dividends. It is calculated by subtracting the company's cash
position from the company's short and long-term debts, and then
dividing that by the company's equity position. The lower this
ratio, the better it is for not only the company in question, but
for us as investors. Ratios under one are typically considered to be
Table 6: Net Debt To Equity Ratios of Altria,
Reynolds American, and Lorillard
Table 6 shows that Reynolds American looks best in
this category. A meaningful figure could not be calculated for
Lorillard due to a negative equity position. However, we should
consider the fact that Altria has $26.3B worth of treasury stock on
its balance sheet, which represents a reduction in equity. Tobacco
companies usually don't need a lot of equity in order to operate, as
they don't need to make continuous infrastructure investments. For
this reason, many of these companies will choose to use their equity
to buy back stock. This decision will reduce a company's equity
position, artificially inflating the company's net debt to equity
ratio, making the company appear to be financially-distressed when
it really isn't. If you strip the treasury stock from the
calculation of Altria's net debt to equity ratio, Altria comes in
with a net debt to equity ratio of just 0.37. Reynolds American and
Lorillard do not have treasury stock on their balance sheets. So,
both Altria and Reynolds American look really good in this area.
Forecasted Earnings Per Share Growth
Dividend growth can be driven by a couple of
different factors. One of these factors is the expansion of the
company's payout ratio, where the company decides to pay out a
higher percentage of its earnings or free cash flow to shareholders
as dividends. However, you can only expand the payout ratio so much.
Eventually, you must have free cash flow growth in order to pay
steadily increasing dividends. And, we all know that free cash flow
growth comes from earnings growth. To get a good idea as to the
prospects of a company's future dividend payments, it may behoove us
to look at analyst projections for future earnings per share growth
over the next couple of years. Table 7 shows the forecasted earnings
per share growth rates for Altria, Reynolds American, and Lorillard over the next
couple of years. These numbers come from the analysts at S&P Capital
Table 7: Forecasted Earnings Per Share Growth for
Altria, Reynolds American, and Lorillard
Table 7 shows that while both Altria and Reynolds
American are expected to show solid earnings per share growth in the
upper single-digit range, Lorillard looks even better, with
double-digit earnings growth slated for 2014. This bodes very well
for dividend growth at Lorillard.
Today, we have looked at a number of different
factors in order to determine the strength and sustainability of the
dividends of Altria, Reynolds American, and Lorillard. These factors include the
dividend yield, historical dividend growth rates, payout ratios,
interest coverage ratios, net debt to equity ratios, and analyst
projections for future earnings per share growth.
While all three of these companies exhibit strong
dividend yields and solid track records of dividend growth, Altria
concerns me a bit, as they are paying out nearly all of their free
cash flows in dividends. Reynolds American is paying out all of its
free cash flows at the moment. This means that in order for these
two companies to continue to increase their dividends, they will
need to increase their free cash flows. Based on this, along with
earnings per share projections, we can expect Altria and Reynolds
American to continue posting dividend growth in the mid to upper
Lorillard, on the other hand, has the highest
dividend growth rate, the lowest payout ratios, and the strongest
earnings per share growth forecast. While we can't expect 12%
dividend increases to go on forever, based on the figures outlined
today, Lorillard's dividend looks very sustainable and primed for
more growth ahead than those from Altria and Reynolds American, as
long as the FDA doesn't make the rash decision of banning menthol