At first glance, investors might not see the similarity between Altria's (MO -0.37%) cigarettes and Procter & Gamble's (PG -0.78%) toothpaste. The key connection is that they are both cash cows being milked for the benefit of shareholders. But there is an important distinction here that income investors need to understand, and it explains why P&G's 2.4% dividend yield might actually be a better long-term choice than Altria's lofty 8.3% yield.
Why cash cows are great for dividend investors
A cash cow product is basically an existing offering that customers buy on a regular basis. Generally, the product solves a basic need or desire. A good example of this is toothpaste, where P&G owns the Crest brand.
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Toothpaste helps keep teeth healthy. Dentists recommend its use, normally twice a day. People buy more as soon as they run out. Technically speaking, there's no particular need for more than a single toothpaste brand or flavor. Demand would still be consistently high because of the nature of the product.
But there are different brands and flavors and formulations of toothpaste. Essentially, companies like P&G are trying to entice customers to fall in love with their variation of toothpaste. And once that happens, P&G has a customer it can count on to regularly buy its product.
The income stream created by Procter & Gamble's toothpaste is reliable and can be used to reward shareholders with dividends (among other things, like reinvest in the business). This is basically why consumer staples stocks have some of the longest dividend streaks you can find, with P&G's 67 annual increases making it a proud member of the Dividend Kings club. Other consumer staple Dividend Kings you might recognize include Colgate-Palmolive and Kimberly-Clark. There is tremendous overlap between the products all three of these companies sell.
Not all cash cows are the same
Altria has a cash cow product as well: cigarettes. Doctors do not recommend cigarettes. They are not healthy. And the addictive nature of the nicotine in the product is what keeps many people coming back for more. Even the most committed cigarette users are likely to try to quit the product at some point, helped along by society's negative view of smoking. The trend is not in Altria's favor. Over the past five years, the volume of cigarettes it has sold fell 23%.
How is that a cash cow? Because of the nature of cigarettes, Altria is able to increase prices to offset the volume decline. The cash it is generating from the business fuels its huge dividend. To be fair, P&G raises prices regularly, too, but there's an important difference. To justify price increases, Procter & Gamble brings out new flavors and uses innovation to add benefits. It charges more by giving more to customers. Altria largely just raises prices without making any changes to its cigarettes at all.
Innovation is one of the most important things that well-run consumer staples companies bring to the table. During earnings calls and industry conferences, businesses like P&G will brag about the new and improved offerings they are selling. And if the innovation is already in the market and producing strong results, executives will happily tell anyone that will listen how great things are going. Altria is just raising prices, charging more and more even as it sells fewer and fewer cigarettes without giving its customers any reason to keep buying. That's a terrible deal for customers and, eventually, the company's cash cow is likely to run dry.
Innovation is the better bet
When you are looking at dividend stocks, you have to assess the risk/reward trade-off between yield and dividend sustainability. Is Altria's high yield sustainable over the long term? Given the poor outlook for its cash cow cigarette business, the answer is probably no. That said, it is hard to predict when the milk will stop flowing, as naysayers have been using this argument for more than 20 years without seeing the company fail. Nevertheless, volume declines will eventually be a problem too large to overcome with price increases. If you buy Altria, you'll want to watch the ongoing volume declines very carefully. Most investors will probably be better off avoiding the shares.
Will P&G continue to increase its more modest dividend like it has in the past? That seems highly likely as it continues to innovate to keep its cash cow businesses (toothpaste is just one of many) fresh and growing. P&G's brighter outlook will probably be a better fit for all but the most aggressive dividend investors.
