Tobacco stocks hold a special place in the hearts of many dividend investors. Long subject to public thrashings, and home to corporate malfeasance, Altria Group (NYSE:MO), Philip Morris International (NYSE:PM), and Reynolds American (NYSE:RAI) have nonetheless rewarded income investors for decades. Let's look at the state of tobacco dividends and see which company offers the best deal for investors today.
A history of strong dividends
Tobacco stocks have historically provided investors with strong and growing dividends. Over the last four quarters, Altria paid $2.08 per share in dividends -- a 4.2% yield. Reynolds American sports a 4.1% dividend yield and Philip Morris yields 4.6%.
More important, each of these companies has a long history of raising its payout. Altria has increased its dividend 47 times in the last 44 years. Reynolds American has raised its dividend 11 times in the 10 years since its formation. Philip Morris has boosted its dividend every year since being spun out of Altria in 2008. If the trend continues, dividend investors will be richly rewarded for owning these tobacco stocks.
Can the dividends continue?
Of course, the recurring concern about tobacco stocks is that regulation and changing consumer habits will reduce cash flow, thus imperiling their dividends. Cigarette consumption has been declining in developed nations for some time, creating a headwind for tobacco companies.
Tobacco companies have so far offset consumption declines with higher prices. Altria, Reynolds American, and Philip Morris each distribute premium cigarette brands that command pricing power. By raising carton prices, the companies can grow earnings even as volume declines.
Moreover, recent evidence suggests cigarette volumes are stabilizing in the U.S. After a big decline in 2013, industry executives are seeing a return to low single-digit decline rates. In its third-quarter earnings call, Reynolds American estimated that industry cigarette volume was down just 2.7% compared to the same quarter in 2013. "Industry volumes moderated. We're looking now at about 3.5% [decline] for the year," said Reynolds American CEO Susan Cameron. That's much better than U.S. cigarette volume's 4.6% fall in 2013.
If the decline remains moderate, premium cigarette brands will likely be able to raise prices faster than volumes decline -- meaning more cash will flow to tobacco stockholders.
Which dividend is the best?
Even as the big picture brightens for all three tobacco companies, some dividends are safer than others. Many investors focus on earnings coverage of the dividend -- usually expressed as the payout ratio -- but dividends are paid in cold hard cash. Let's check out each company's dividend as a percentage of cash from operations:
From this perspective, Philip Morris looks like the safest long-term bet, since it has room to raise its dividend for several years even if cash flow remains stagnant. Altria has the highest "cash payout ratio," using 84% of its cash flow to pay its last four quarters of dividends.
On the other hand, Reynolds American has enough cash on its balance sheet to pay one year's worth of dividends, so its cash payout ratio is more in line with Philip Morris'. Reynolds American's competitive position could also grow stronger if the company completes its merger with Lorillard (UNKNOWN:LO.DL), adding an additional layer of safety to the dividend.
Investors seeking immediate gratification might want to go with Philip Morris' 4.6% dividend yield. However, Reynolds American's 4.1% yield could end up being the safer long-term bet if regulators allow it to acquire Lorillard and dominate the menthol market.
Still, risks remain for all tobacco companies, so dividend investors should keep an eye on cigarette trends and regulation in coming years.
Ted Cooper 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.