3 Reasons Why Reynolds American Could Remain a Top Dividend Stock

Tobacco plant. Source: Reynolds American.

High-yield dividend stocks have become a staple for the portfolios of income investors, as other income-producing investments have seen their yields decline precipitously. Among the most fertile areas for high dividends is the tobacco industry, and Reynolds American (RAI) currently sports a solid dividend yield of 4.5%, roughly double the yield for the broader market. Yet as Reynolds American shareholders contemplate the company's proposed merger with Lorillard (LO.DL), one key question is whether Reynolds will make any changes to its dividend policy assuming the merger goes forward as planned.

The Reynolds-Lorillard merger has the potential to change the playing field in U.S. tobacco, with the combined entity challenging rival Altria (MO 0.70%) for dominance of the market. But will dividend investors be happy with the coming fight? Let's take a look at three reasons why Reynolds American might sustain its status as a top dividend stock.

1. Reynolds American has committed to retaining a solid dividend even after the Lorillard merger goes through.

One of the biggest challenges that merging companies have to deal with is what to do with their dividend. In many cases, companies end up spending a great deal of cash in order to make an acquisition, and the temptation to reduce dividends in order to recover some of that lost cash flow can be strong.

But Reynolds American has already reassured nervous shareholders that it intends to maintain its current dividend policy until the Lorillard merger is complete. More importantly, going forward, Reynolds American intends to target a dividend payout ratio of 75% for the combined company. That's less than the 88% payout ratio that Reynolds currently pays, based on its most recent earnings over the past 12 months. But with Reynolds expecting the acquisition to be accretive to earnings within the first full year after it closes and with even stronger growth potential in future years, it might not take very long for Reynolds American's earnings to catch up with its dividend and start making more dramatic dividend increases possible.

2. Development of the menthol cigarette market could give Reynolds American a key competitive advantage.

Even after the merger, the combined Reynolds-Lorillard will still trail Altria in terms of cigarette market share, albeit by a much narrower margin. But by combining Lorillard's dominant Newport brand with Reynolds American's menthol versions of popular brands like Camel, Reynolds could take a commanding share of the important menthol cigarette market.

Reynolds American's marketing campaigns only target smokers over 21. Source: Reynolds American.

That concentration comes with some risks as well, as recently the Food and Drug Administration has considered putting specific restrictions on menthol cigarettes. The FDA asserted in a report last year that menthol cigarettes have disproportionate appeal to younger smokers and make it harder for those seeking to quit smoking. With the FDA having banned other forms of flavoring five years ago, the agency is likely to keep pursuing menthol. Yet Lorillard has argued that the FDA study is scientifically flawed and that any eventual regulation will be minor. To the extent that the market is discounting menthol's prospects, any positive development could create more profits for Reynolds American after the merger and support higher future dividends.

3. Further divestments could create special-dividend opportunities.

Source: Reynolds American.

Some investors have been concerned that regulators could threaten to block Reynolds American's merger with Lorillard. In late August, the Federal Trade Commission requested additional information from both companies, extending the waiting period under which the FTC can consider its regulatory review of the transaction. Already, the companies have agreed that Lorillard will sell off its e-cigarette line, blu, leaving Reynolds with its Vuse product as its representative in the fast-growing e-cigarette market. Moreover, a number of Lorillard's cigarette brands will end up in the hands of Imperial Tobacco Group, with Reynolds likely believing that divesting those brands will improve the odds of approval.

Nevertheless, if the FTC requires further divestitures from Reynolds before approving its acquisition of Lorillard, it could create an even larger pool of available cash for the company. That in turn could lead Reynolds American's management to consider moves like enhanced share buybacks or a special dividend, rewarding those who stuck with the stocks during the uncertainty. The two companies haven't said anything about possible further divestitures, and they still expect the deal to close in the first half of next year.

Uncertainties surrounding the Lorillard acquisition have dividend investors feeling somewhat uncomfortable with Reynolds American's future prospects. Yet with considerable upside potential, Reynolds American still looks poised to remain a top dividend stock as long as everything goes well with its merger plans.