Dividend Report Card: Reynolds American

In this series, we analyze financial metrics to begin answering the following questions about a company's dividend:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

The Dividend Report Card wasn't designed as a buy or sell signal but rather as a tool to gauge the health of a company's dividend. For a full explanation of each category, click here for a tutorial.

Today's pupil is Reynolds American (NYSE: RAI), which posts a 6% dividend yield.

Dividend history

Source: Capital IQ.

Reynolds American recently announced its seventh dividend increase since being formed in 2004 and it's boosted its payout at a good clip over the past five years, so it scores a 5 of 5 in this category.

Sustainability

Source: Capital IQ, a division of Standard & Poor's, as of March 29.

Reynolds American's balance sheet appears fairly strong as it covers each $1 in interest expenses with $11.40 in operating profit, and Morningstar gives it an investment-grade credit rating of "BBB."

In December, Reynolds' board increased the target earnings-based payout ratio from 75% to 80%. That brought their target in line with Altria's and sent a clear message to the market that dividends will be the primary source of shareholder returns going forward.

At face value, the current dividend looks sustainable as long as Reynolds can grow the business at even a very modest rate in the coming years. With little need for capital investment, Reynolds generates a tremendous amount of free cash flow.

Still, the high payout ratios leave little room for error and if Reynolds' earnings come under pressure, the dividend could follow suit.

Growth

According to Capital IQ, the median analyst estimate for long-term EPS growth is 6%, but I would expect dividend growth over the next five years to fall closer to 2%-4%.

That's because organic growth is limited and much of Reynolds' dividend growth of the past five years came from an expanded payout ratio, which increased from 55% in 2005 to 94.3% in 2010. To put this into some perspective, if we apply the 80% target payout ratio to earnings from 2005 to 2010, the dividend growth rate would have been closer to 2% annualized.

Competitors
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against that of direct competitors. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Compared to this group, Reynolds' current yield of 6% seems a bit high relative to what's expected from Altria and Lorillard, but it's definitely not an outlier.

Pencils down!
With all the numbers in, here's how Reynolds American's dividend scored:

Reynolds American's 6% dividend may be three-and-a-half times the S&P 500 average of 1.7%, but it certainly isn't without its risks. If it can grow its dividend at the rate of inflation going forward, investors should be happy, but it would be folly to expect a repeat of 11% dividend growth or anything close to that rate over the next five years.

Have you added Reynolds American to your Watchlist? Well, what are you waiting for?