Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low, it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
Today, and one day each week for the rest of the year, we're going to look at one dividend-paying company that you can put in your portfolio for the long term without too much concern. This isn't to say that these stocks don't share the same macro risks that other companies have, but they are a step above your common grade of dividend stock. Check out last week's selection.
This week, I'm going to dip into a sector I normally scream avoidance over and rile a few socially responsible investors in the process by recommending investors embrace U.S. tobacco producer Lorillard (NYSE:LO).
Getting to the butt of the problem
If I were to list all of the concerns that Big Tobacco is facing in the United States, we'd be here all day. But, if I could narrow it down to the two biggest problems the sector is facing, it'd be increased educational awareness with regard to the dangerous effects of smoking, which has reduced the number of new and current smokers, and new laws and taxes being implemented and suggested to discourage smoking.
The effort to reduce the appeal of smoking has been swift and direct. The Centers for Disease Control and Prevention launched a three-month, $54 million multimedia graphic ad campaign last year targeted at getting 50,000 young adults to quit. The Food and Drug Administration is doing its part as well in petitioning tobacco companies to supply it with quantity levels of some 20 disease-causing agents in cigarettes, which it then hopes to make public to further increase smoking danger awareness.
The end result of these multiple actions has been an ongoing reduction in smoking rates over the past four decades and tougher times for U.S. tobacco producers such as Altria (NYSE:MO) and Reynolds American (NYSE:RAI). In fact, a tough domestic sales climate was one reason Altria decided to spin off its overseas operations into Philip Morris International (NYSE:PM) in 2008. By separating its business, the hope was that investors would have a better understanding of the fundamental forces driving Altria and Philip Morris.
It still hasn't been easy for U.S. big tobacco. In fact, Altria has shed 15% of its U.S. workforce, and Reynolds American 10%, because of declining cigarette volumes and the need to reduce expenses to keep profits (and dividends) up.
Lorillard is smoking its competition
Lorillard's advantage over its peers can be traced to its outperformance in premium, discount, and e-cigarette products.
There's no sugarcoating that cigarette volumes are falling in the United States. In the first quarter, Lorillard delivered a 1.3% decline in sales of its premium Newport brand compared with the previous year. However, all things considered, this was much better than the 6.2% decline in overall domestic cigarette shipments for the industry as a whole. Furthermore, Lorillard was able to use its solid pricing power to help profits in this segment rise by nearly double digits on a non-GAAP basis while further improving its premium market share by 0.5% to 12.7%. As Altria's premium Marlboro brand struggles to maintain its market share, Newport continues to reap the benefits.
But, it isn't just Lorillard's premium brands that are doing the talking! Lorillard's discount brands, such as Maverick and Old Gold, are giving discount-only brand Vector Group (NYSE:VGR), as well as traditionally bigger tobacco producers Altria and Reynolds American a run for their money. This helped push Lorillard's overall cigarette market share up 0.4% year over year to 14.9%. Not surprisingly, Lorillard has delivered market share increases in each of the past 10 years!
Lorillard is also taking advantage of smokers' addiction with regard to e-cigarettes, a new product designed to release vapor instead of smoke, which is far healthier for the user and his or her surrounding family and friends. In the first quarter, Lorillard's blu e-Cigs delivered $57 million in revenue.
Show me the money, Lorillard
It's not hard to come by a dividend in the tobacco sector, but finding a company with an expanding bottom line that has a sustainable payout is far from easy.
You would think a company like Vector Group would be perfectly set up to benefit from consumers' desire for cheaper cigarettes with its discount brands. While partially true, discount cigarettes come with lower margins, meaning Vector needs to work twice as hard to make as much as its considerably larger peers. To top this off, its dividend and overall financial health could be in serious jeopardy if one of the many lawsuits against the sector results in a huge fine. Vector is just a fraction the size of Altria or Reynolds American, so it comes with its own set of risks.
Similarly, Altria and Reynolds American are working their balance sheet magic by reducing headcount (and thus expenses) and rebuying stock to make it appear as if the company is delivering top-line growth. With Lorillard you aren't going to find layoffs. Instead, you'll find a company that's delivered consistent market share gains for a decade now that's doing its best to reward shareholders through share buybacks and sizable dividend increases.
In May, Lorillard doubled its share repurchase allotment by authorizing the purchase of an additional $500 million worth of shares. Keep in mind, this comes on top of the $390 million it spent in the third and fourth quarters of 2012 combined, and the $149 million in the first quarter, on share buybacks. Share buybacks aren't an instant payment to shareholders, but it does help make a company appear cheaper on a P/E basis, which can occasionally help push the share price higher.
Where Lorillard is really making an impact is with its growing dividend. Despite being spun off just five years ago from property and casualty insurer Loews, Lorillard has already kicked in five straight years of payout increases to shareholders -- with its most recent increase being a 6.5% boost in February -- totaling a cumulative 79% increase on a quarterly basis since it instituted a quarterly payout in 2008.
The current yield on Lorillard is a delectable 5% and puts it at nearly double the current yield of a 10-year Treasury note. Another way to think about this is that with these dividends reinvested back into the company's stock, you'd double your money on payouts alone in less than 15 years! At a payout ratio of 70.5% based on this year's projected EPS, Lorillard is striking a great balance with investors of paying out a sizable chunk of its profits while also ensuring that its dividend has a little downside buffer, should demand weaken.
Sometimes the best hidden gems are found in sectors that have the most questionable long-term outlooks. Having cornered a good chunk of the menthol cigarette market share, Lorillard should be able to mount growing market-share gains and significant pricing power in comparison with Altria's Marlboro, which is fighting for its life to keep its current market share. With a rich history of shareholder incentives ranging from share buybacks to rising dividends, there's little reason to believe Lorillard won't be a pillar of strength in the U.S. tobacco industry for investors for years to come.
Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool owns shares of, and recommends, Loews. It also owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.