Solid dividend-paying stocks are the cornerstones to many retirement portfolios. And when it comes to dividend payers, few industries have a better track record than the tobacco giants. Controversial as they may be, the economics are undeniable: The addictive nature of cigarettes allows companies to spend little on capital expenditures, while raking in tons of cash flow.
Last year, Reynolds American (RAI) was one of the top performers in the S&P 500, returning 49% for investors after including dividends. The main driver of that move was the fact that the company completed its acquisition of Lorillard -- and now owns roughly one-third of the U.S. tobacco market. Altria, maker of Marlboro, has the top spot, with just over half of the market.
But in this article, we will be exploring Reynolds' dividend, which currently yields an attractive 3.1%. Should investors hope for an increase in the coming year?
Checking under the dividend-paying hood
When it comes to checking on the health of a company's dividend, financial media focuses squarely on how much of earnings is used to pay out the dividend. This is called the "payout ratio." Generally, a lower payout ratio is preferable, as it shows that a company has room to grow its dividend, or sustain it during an industry downturn.
Here is Reynolds' payout ratio from earnings per share over the last four years:
There's nothing wrong with a payout ratio of 73%, as it allows for some wiggle room for incremental dividend increases. Generally speaking, investors should be somewhat concerned to see the payout ratio changing so drastically over just four years.
But in the case of Reynolds, much of this is planned. The company stated in its last quarterly report that its policy is to pay "dividends ... aggregate amount that is approximately 75% of RAI's annual consolidated net income."
However, I've long believed that there is an even better indicator as to a company's dividend: the payout ratio from free cash flow. While net income and EPS can be massaged and finagled with accounting tricks, cash flow is a much more straightforward way to measure how much actual cash a company has put in its pocket.
Free cash flow itself is a measure of cash gained from operations (selling cigarettes), minus any capital expenditures (like expanding production facilities). At the end of the day, it is from free cash flow (and a company's cash balance) that dividends are paid out.
When we look at Reynolds' payout ratio, it's important to note that Reynolds' ratio over the past 12 months was actually negative because the company's free cash flow was negative as a result of its acquisition of Lorillard.
Overall, this doesn't paint the most comforting picture. The company is using virtually all -- and sometimes more -- of its free cash flow to pay out dividends. That's possible when you have lots of cash on hand, which Reynolds does, with $3.2 billion sitting in the bank. But the company also has over $17 billion in long-term debt.
On the whole, this is how I'd evaluate Reynolds as a dividend stock. It is highly likely that the company will increase its dividend in 2016. It has done so every year since it started paying a dividend in 2004, with the exception of 2008, at the height of the Great Recession.
At the same time, dividend investors need to keep a keen eye on free cash flow. It's entirely possible that the acquisition of Lorillard will help Reynolds drive more free cash flow, and thus, safely increase its dividend. However, if continuing declines in smoking combined with failed efforts to establish a profitable e-cigarette business occur, I wouldn't be surprised to see Reynolds' dividend get cut.
That's not a serious threat right now, but its something for investors -- especially those nearing retirement -- to consider.