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Which Of These Three Domestic Tobacco Stocks Has The Best Dividend?

March 5, 2014

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 earnings growth.

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.

Dividend Yield

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.

Altria 5.3%
Reynolds American 5.3%
Lorillard 5.0%

 

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.

Dividend Growth

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.

Altria 8.4%
Reynolds American 9.2%
Lorillard 14.1%

 

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.

Company TTM 4-Year Average
Altria 76% 76%
Reynolds American 78% 76%
Lorillard 68% 71%

 

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 regard.

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 net income.

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.

Company TTM 4-Year Average
Altria 85% 95%
Reynolds American 116% 100%
Lorillard 73% 68%

 

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 ratios.

 

Table 5 shows the interest coverage ratios of Altria, Reynolds American, and Lorillard over the last 12 months.

Altria 7.7
Reynolds American 11.6
Lorillard 11.3

 

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 good.

Altria 2.74
Reynolds American 0.70
Lorillard NM

 

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 IQ.

 

Company 2014 2015
Altria 8% 7%
Reynolds American 6% 8%
Lorillard 14% 8%

 

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.

Conclusion

 

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 single-digit range.

 

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 cigarettes.

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WallStreetBeerMoney.com

"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"

dave@wallstreetbeermoney.com