A primary reason that retail investors still flock to tobacco companies is that they pay large dividends. Altria Group (NYSE:MO), Philip Morris International (NYSE:PM), Lorillard (NYSE:LO), and Reynolds American (NYSE:RAI) have paid above-average dividends for years.
However, too many individual investors focus only on the dividend history instead of each company's ability to raise its dividend in the future. By taking a deeper look at the factors that affect dividend payouts, investors can find the most promising dividend stock.
Since tobacco companies tend to have liberal dividend policies and limited growth prospects, they usually offer above-average dividend yields. The average S&P 500 index company yields approximately 1.9%. Altria, Philip Morris International, Lorillard, and Reynolds American each exceed the average by a factor of two.
If you only look at the dividend yield, they all look pretty similar. But once you dig deeper, you will find that there is a bigger difference between the best dividend and worst dividend than their yields suggest.
Which stock has the best ability to raise its dividend?
For dividend investors, the most important aspect of a stock is its ability to increase the dividend in the future. One way to determine how much management can increase the dividend is to look at the payout ratio -- calculated as dividends paid divided by earnings. The lower the payout ratio, the greater the company's ability to increase the dividend.
An even better metric to examine than the payout ratio is to look at three-year average cash flow from operations divided by the dividend payment. This metric is better than the payout ratio for two reasons. First, it uses cash instead of earnings to calculate dividend coverage. Companies pay dividends in cash, not earnings, so knowing how much cash is coming in relative to the dividend is an important consideration. Second, it uses average cash flow, which gives a much better picture of normal cash flow than any one year.
Over the last three years, Altria averaged $3.4 billion in cash from operations. It paid $3.5 billion in dividends over the last four quarters. Altria is pushing its dividend to the limit by aggressively paying out its cash flow. On the other hand, Philip Morris International and Lorillard generate significantly more cash than they pay in dividends, meaning that they have room to raise their dividends in the near future. Reynolds American is in a position similar to Altria and will need to continue growing cash from operations in order to increase its dividend.
One of the reasons Altria can pay such an aggressive dividend is that it has a lot of cash on its balance sheet. As of its most recent quarterly filing, Altria has $4.2 billion in cash and equivalents on its balance sheet -- close to 1.2 times its last four quarters of dividend payments. Cash on hand gives it the ability to keep paying its dividend even if cash from operations comes in below expectations.
However, investors should prefer cash coverage like that of Lorillard and Reynolds American, which could close down for two years and still maintain their dividends. Philip Morris International does not have much cash on hand relative to its dividend, but its cash from operations is so high that there is little doubt about its ability to increase its dividend in the future.
Competitive position and market opportunity
Intense regulation of the tobacco industry has solidified the big tobacco companies' respective market share. Altria is the largest player in the U.S. market. Its Marlboro brand captures a 42.6% market share, bringing the company's total market share to slightly less than 50%. Philip Morris International, the international distributor of Marlboro, has a 29% global market share excluding China and the U.S. Lorillard's Newport brand dominates the U.S. menthol market; Newport has a 37% share of the U.S. menthol-cigarette market and Lorillard has a 40.4% of the U.S. menthol market overall.
Finally, Reynolds American is the No. 2 U.S. cigarette manufacturer, behind only Altria, and owns five of the top 10 U.S. brands. The majority of its sales come from the more profitable premium category. Since severe advertising restrictions make it difficult for any company to steal significant market share, none of these companies is at significant risk of losing ground.
Moreover, all four companies have an opportunity in e-cigarettes. E-cigarettes are purported to be much safer than traditional cigarettes and could soon become an important part of the cigarette market. All of the big tobacco companies could easily dominate the e-cigarette market by adding line extensions to their traditional cigarette brands. This will enable them to boost free cash flow and pay higher dividends.
Of the four companies discussed, Philip Morris International and Lorillard have the most attractive dividends. They both yield more than 4% and have significant cash coverage. Altria and Reynolds American are the most generous dividend payers, but their ability to raise their dividends in the coming years will be hampered by low cash coverage.
Fool contributor Ted Cooper has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.