Where Next for British American Tobacco's Dividend?

LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, because dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.

A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and I.

In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 to see whether their dividends are being funded in a sustainable way -- from genuine spare cash. Today, I'm looking at income favorite British American Tobacco (BATS 0.74%) (BTI 0.78%).

Does British American Tobacco have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments, and tax deductions. With that in mind, let's look at BAT's cash flow from the last five years:

Source: British American Tobacco annual reports. *A value of more than 1 means the dividend was covered by free cash flow.

Tobacco: The ultimate defensive investment?
British American Tobacco's operations benefit from big efficiencies of scale and pricing power, which makes them impressively profitable: The company's five-year average operating margin is 32.1%. As a result, BAT generates a lot of free cash flow, most of which has been returned to shareholders via dividends and share buybacks, both of which have been ramped up over the last five years.

BAT's dividend has doubled since 2007, and the company spent $978 million on share buybacks in the first nine months of 2012 alone. Tobacco proved to be one of the safest and most attractive defensive investments during the financial crisis, and BAT's share price has also risen, gaining 70% over the last five years -- not bad for a FTSE 100 company.

Although much of British American Tobacco's profitability is the result of its high profit margins, its powerful range of brands has also enabled it to expand into emerging markets and exert considerable pricing power across all of its markets. Smokers in emerging markets will happily spend a little extra to smoke a famous brand like Dunhill, Lucky Strike, or Pall Mall, and in the first half of last year, BAT delivered volume growth of 3% on its core "Global Drive Brands," alongside 4% revenue growth which it said was driven by "continued good pricing," by which it means the ability to control prices, rather than be controlled by them.

So is it too good to last?

Is BAT's dividend safe?
Leaving aside the never-ending debate about what will happen when tobacco smoking is legislated out of existence -- something I don't expect to see in my life -- we need to understand how secure the company's dividend is and, in particular, how sustainable its current rate of growth is likely to be.

Much of BAT's recent growth and strength is derived from its strong and growing presence in emerging markets. Although the ethics of promoting smoking to poorly educated people might be dubious, there's no doubt that it's an effective way to drive revenue and profit growth, and I think it has further to run. BAT's two highest-volume regions are now Asia-Pacific and EEMEA (Eastern Europe, Middle East, and Africa), which together accounted for 62% of the company's volume in the first nine months of 2012.

At the same time, I think BAT's dividend payout is reaching the limit of what's affordable in terms of cash flow, and I agree with brokers' consensus forecasts, which suggest that dividend growth will slow to about 7% per year over the next couple of years, down from 10% to 15% per year over the last few years.

Despite this, BAT is likely to retain its impressive ability to generate free cash flow for many years to come, and I believe its current 4% dividend yield is a pretty safe bet for the next couple of years at least and will continue to grow ahead of inflation.

Top income tips
British American Tobacco is one of the biggest holdings of legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the 15 years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%. Mr. Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. You can learn about Neil Woodford's seven other largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but it's available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.