The tobacco sector is a tried-and-true source of dividends. Investors have counted on tobacco stocks for reliable quarterly dividend payments for several decades. One of these dividend stalwarts is Lorillard (NYSE:LO), the third-largest tobacco company in the United States, which traces its roots all the way back to 1760. Its Newport brand is the top-selling menthol cigarette brand in the country.
Lorillard is widely recognized as a favored pick among income investors. Based on its dividend yield and track record of rewarding shareholders, it's clear that Lorillard has earned this reputation. Here are three reasons why Lorillard is a top dividend stock.
Reason No. 1: A high dividend yield
With interest rates stuck at historic lows and stock prices sitting at all-time highs, yield can be hard to find. That's partly why tobacco companies have earned their reputations as great dividend stocks. The tobacco sector is one of the last sources of high dividend yields on the stock market. Indeed, Lorillard's 4% dividend yield is roughly double the dividend yield of the stock market as measured by the S&P 500 Index.
Lorillard can afford such a generous payout because it generates the cash flow to support it. Tobacco companies are renowned for their ability to earn very high returns on capital. Over the first nine months of the year, Lorillard generated $676 million of free cash flow. The beauty of the tobacco business is that since companies don't need to spend a lot of money on capital expenditures, they can afford to return most of their cash flow to shareholders. Lorillard returned 98% of its free cash flow to investors as dividends over the first three quarters this year.
Reason No. 2: High dividend growth
In addition to a high dividend yield, Lorillard has a history of increasing its dividend every year. That means income from owning Lorillard is significant now, and gets even better over time. Lorillard raised its dividend 12% in February. This bump represented the sixth dividend increase since Lorillard became an independent publicly traded company in 2008. Lorillard has proved it is a solid dividend growth stock. In those six years, Lorillard has doubled its dividend. Over the past five years, Lorillard has increased its dividend by 13% compounded annually.
With that kind of growth, the potential income investors can receive by owning Lorillard for many years is staggering. If an investor buys Lorillard today at a 4% dividend yield, and the company increases its dividend by 10% per year (below its recent average), that investor's yield on cost five years from now will be 6.4%. If that investor reinvests dividends along the way, the yield on cost will be even higher. This demonstrates the power of dividend growth as a means of generating increasing income over time.
Of course, in order for Lorillard to keep growing its dividend, the company needs to continue growing earnings. This might seem difficult in light of the continued decline in smoking. Indeed, the number of people smoking declines a few percentage points each year, and that trend is expected to continue. Fortunately for Lorillard, the company has a plan to offset this by raising prices and cutting costs. Lorillard grew revenue and adjusted earnings per share by 0.3% and 6% over the first nine months of 2014, year over year, due to price increases and cost cuts. Continuing this will help the company grow earnings and dividends even though the number of smokers will decline.
Reason No. 3: Management commitment to dividends
Lastly, investors should view Lorillard as a top dividend stock because management is fully committed to the dividend. Lorillard generates a lot of cash, and management does a great job of not wasting it. Lorillard generated a 28% earnings before interest, taxes, depreciation, and amortization, or EBITDA, margin through the first three quarters. It keeps its costs manageable, which frees up cash for dividends.
Lorillard also does not spend a lot of money on rewarding shares to employees. In fact, Lorillard's share buybacks reduced the company's fully diluted share count by more than 12 million shares last quarter versus the same quarter the prior year. Effectively eliminating shares eases the financial burden that dividends have on the company.
Lorillard is a top dividend stock
Investors count on the tobacco sector for dividends, and that dynamic is entirely justified. Lorillard is a heavyweight in the tobacco industry. It pays a high 4% dividend yield and also does a great job of raising its dividend each year. While it's true that Lorillard distributes almost all of its free cash flow, which may impede its future dividend growth potential, there is plenty of room for Lorillard's dividend growth to continue. Lorillard management runs a clean operation, with high margins and returns on capital. Going forward, it's reasonable to forecast high single-digit dividend increases once Lorillard is acquired by Reynolds American next year. Until then, Lorillard is a top dividend stock.
Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.