Why the Tobacco Giants Remain Among the Best Dividend Stocks

The cost of smoking is going up.

Income investors pursuing the best dividend stocks typically check the payout ratio to determine a dividend's sustainability, but when it comes to tobacco giants Altria (MO 0.86%), Lorillard (LO.DL), and Reynolds American (RAI), all you need do is look at the price hike they're taking with a pack of cigarettes to understand there is no danger to their dividends.

The payout ratio divides the dividends paid out to investors by the company's net earnings. Sometimes operating cash flows are substituted for earnings because they're less subject to manipulation. Either way, investors are balancing how much a company brings in with how much it pays out, and a payout ratio of 75% or less is often considered sustainable.

Put another way, if a company is returning three-quarters or more of its earnings to shareholders as dividends, there is little left over to reinvest in its operations.

Looking at the cigarette makers' payout ratios, investors might see a yellow flag as Altria and Reynolds are paying out around $0.90 in dividends for every dollar they bring in in profits. Since they're paying out almost all of their net income already, there's little chance they can increase the dividend much further in the future.

While the 75% threshold is a good rule of thumb, there are always exceptions because slow-growth businesses might return more to investors so they can earn more on their own than had the company reinvested the money in its operations.

And that argument can certainly be made with the tobacco companies, but because cigarette volumes continuously fall each year, sustainability may still be a worry. Investors, though, can probably breathe easy as the tobacco companies take steps to charge more for their traditional products and branch out into new products.

Earlier this month, the Big Three cigarette makers all announced they would be initiating price hikes of $0.07 per pack, or $0.70 per carton, indicating confidence they still have substantial pricing power, and the industry remains as healthy as ever. Even smaller tobacco shops like Vector Group (VGR 0.72%) said they would be taking similar price hikes.

According to Management Science Associates, domestic cigarette shipments decreased 4.7% in 2013, more than double the 2.2% rate seen in 2012. Lorillard says industry wholesale shipments were down 2.3% last quarter.

Because it will be the cigarette companies' ability to raise prices in the face of declining consumption that determines their relative strength, the fact they took such a large increase -- and according to Wells Fargo analyst Bonnie Herzog, took it a week earlier than last year -- shows they've got plenty of muscle still.

The bigger risk, perhaps, is the growth of electronic cigarettes and personal vapor systems, or PVSs. Herzog said the vaping industry continues to accelerate, and expects it to rise 4.2% in the third quarter. The market researchers at IRI are even more bullish on vaping, saying the entire category enjoyed double-digit growth in each of the last three four-week periods.

The entire tobacco market has been thrown into tumult by e-cigarettes. While Lorillard's blu eCig has long been the industry leader, following the national rollout of ecig brands from Altria and Reynolds, Lorillard saw its share slide from owning nearly half the market to less than 30%.

Moreover, IRI found that vaping products from privately held NJOY leapt into the No. 1 spot for U.S. retail vaping sales, accounting for 85% of the segment growth during the past two four-week periods.

Source: Flickr via Lindsay Fox.

The tobacco giants also continue to invest in the newest technologies. When and if the Lorillard-Reynolds merger is approved, the blu eCig brand will be sold to Imperial Tobacco Group (IMBB.Y -0.09%). And Reynolds just announced a new cigarette, Revo, that heats but doesn't burn tobacco.

Alternatives to cigarettes are increasingly popular, and though a similar device was brought to market some 20 years ago, it may have been a case of it simply being a product ahead of its time. Ecigs and vaping systems have made such alternatives more mainstream, and Reynolds American believes its time may have come.

What it underscores, though, is that the tobacco industry is shrinking and expanding at the same time, but -- evidenced by the dividends Altria, Lorillard, and Reynolds American pay -- it's as healthy as it ever was.