How Sustainable Are Big Tobacco's Dividend Payouts?

Tobacco companies like Philip Morris (PM -2.96%), Altria (MO 1.45%), Reynolds American (RAI), and Lorillard (LO.DL) are well known for their defensive nature and impressive dividend yields. However, declining cigarette sales also haunt these companies, which is of concern to investors as falling sales mean falling profits, and ultimately this could put pressure on their dividend payouts.

Still, tobacco companies are extremely well-run and their dividend payouts are not going to come under any pressure in the near future; here's why.

Crunching numbers
Philip Morris currently offers a dividend yield of 4.7%, more than double the market average and an attractive rate for many investors. 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 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 team remained cautious. Since then the company's payout has edged up, rising from an initial quarterly payout of $0.46 per share during 2008 to a quarterly payout of $0.94 per share as of the third quarter of this year -- that's growth of 104%.

However, while Philip Morris' quarterly dividend payout has more than doubled, the payout 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.

So investors can buy into Philip Morris for the dividend payout, safe in the knowledge that the dividend is well-covered by free cash flow with plenty of room for future growth.

Unfortunately, Altria's dividend is under much more pressure than that of its larger, international peer.

Back in the U.S.
Unlike Philip Morris, domestic U.S. tobacco companies are paying out a higher percentage of their free cash flow in dividends, which looks worrying.

Specifically, during the last five years, Altria has paid out a total of $16.7 billion in dividends. Over the same period, the company has only generated 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 this gives me confidence in the company's future payouts, although there is still some risk that the company could be forced to scale back its payouts.

Elsewhere, the dividend payouts of both Reynolds and Lorillard also consume the majority of their free cash flows, although overall the payouts look to be well-covered and sustainable.

Source: Marketwatch.com. Figures in $US billions. Rounded to the nearest billion.

It would appear that just like those of Philip Morris, the cumulative dividend payouts of Lorillard and Reynolds American have only risen in line with their cash generated from operations.

How can these payouts continue to rise?
A valid question that investors should be asking is how sustainable are the cash flows of these companies, as the number of smokers around the world continues to slide.

Indeed, a falling number of smokers means lower cigarette sales and ultimately smaller cash flows, which will put pressure on these companies' dividend payouts. Fortunately, big tobacco has thought ahead and is not worried about this issue.

Offsetting falling sales
Big tobacco companies are dealing with falling tobacco sales by increasing prices to offset declining volumes. For example, Altria's most recent price hike came into effect on Dec. 1 as the company added $0.07 per pack to the price of Marlboro cigarettes. This followed a similar $0.06 increase in June.

We can factor this increase into Altria's results to see how it helps keep the company's profits rising.

Specifically, during 2013 the volume of Marlboro cigarettes sold by Altria declined by 4%. However, price increases across the company's tobacco portfolio and lower costs helped Altria's adjusted operating income from smokeable products rise 2.4% during the year.

It's not just Altria that is undertaking this strategy--Reynolds and Lorillard instigated similar price increases throughout 2013. Philip Morris' revenue ticked higher by 3.4% during 2013 while the volume of cigarettes shipped by the company slid 5.1%; this indicates that the company hiked prices.

Foolish summary
Big tobacco companies are known for their impressive dividend payouts, but with the number of smokers around the world on the decline, investors are right to be worried about the sustainability of these payouts.

However, it would appear that tobacco is offsetting falling volumes of tobacco shipped by hiking prices, and for the time being this is safeguarding big tobacco's dividend payouts.