Tobacco companies like Philip Morris International (PM 1.82%) and Altria Group (MO +1.32%) currently offer some of the best dividend yields available in the market. Indeed, while the S&P 500 currently yields an average of 1.9%, Philip Morris currently offers a yield of 4.6% and Altria offers a yield of 5.2%; both are more than double the market average.
However, with the number of smokers worldwide in terminal decline, how safe are these payouts?
Building trust
Tobacco companies are well known for their reliable dividend payouts and they did not get the reputation they have today by breaking their dividend commitments. For example, the dividend payouts of both Altria and Universal Corp have been continually growing for more than 40 consecutive years.
Actually, Philip Morris' management has been extremely prudent in ensuring the long-term sustainability of the company's dividend. In particular, after Philip Morris spun off from what is now Altria during 2008, in its first full year of independence the company generated a free cash flow of $6.8 billion from which it paid out $5.1 billion in dividends to investors.
Now, Philip Morris could have paid out a lot more than this in theory, but the company's management remained cautious. Since then the company's payout has edged up, rising from an initial quarterly payout of $0.46 per share in 2008 to a quarterly payout of $0.94 per share as of the third quarter of this year.
However, while the payout has more than doubled it has only grown in-line with funds generated from operations. In particular, although Philip Morris' payout has risen more than 100% on a per-share basis during the past five years, the company's payout ratio has, for the most part, remained below 60% of free cash flow.
Under pressure
Unfortunately, Altria's dividend is under much more pressure than that of its larger, international peer.
Specifically, for the last five years, Altria has paid out a total of $16.7 billion in dividends. During the same period, the company has only generated a free cash flow of $17.7 billion, which gives a payout ratio of close to 94%.
Nevertheless, Altria has increased its payout 47 times during the last 44 years and the company aims to return 80% of diluted earnings per share to investors ever year, which gives me confidence in the company's future payouts.
Similar traits
Philip Morris' conservative dividend planning is exactly the kind of planning that builds sustainable long-term dividends. American States Water (AWR +2.13%) has one of the longest dividend-payout histories you can find as the company has been paying out its dividend and raising it for 58 consecutive years. Actually, American States shares many traits with Philip Morris. Specifically, the company is highly cash generative with a gross margin of 84% for fiscal 2012, it has low capital-spending requirements, and it operates within a fairly defensive industry -- the provision of water and related services.
Furthermore, American States has increased its dividend payout 60% during the past 10 years; that's a compound annual growth rate of 5.4%, not spectacular but more than inflation. However, during this period, the company has only paid out an average of approximately 30% of its net operating cash flow. This has allowed the company to slowly increase its payout, building trust with investors and keeping the dividend moving higher.
With only 30% net operating cash flow paid out on average per year, American States has plenty of headroom to keep its payout moving higher for many years to come -- even if things turn against the company. This is exactly the same strategy that Philip Morris pursues.
Worrying about growth
Still, some market commentators have raised concerns that Philip Morris' ability to grow earnings and dividends further will be limited due to the declining number of smokers around the world.
I do not have similar concerns. You see, if we look at data from Tobacco Atlas, we can see the tobacco industry evolving in Philip Morris' favor. Specifically, the industry has been consolidating as industry giants buy up smaller regional producers. In effect, this has increased Philip Morris' dominance over the global cigarette market as the company acquires smaller producers. Geographical expansion and consolidation are key features of Philip Morris' growth drive. You can read more about Philip Morris' growth drive here.
For example, the company recently closed a deal to acquire 50% of a major cigarette company located within Algeria and purchased the remaining 20% of a joint subsidiary within Mexico. This industry consolidation gives Philip Morris plenty of room for further growth and should lead to robust cash flows for Philip Morris for some time to come.
