Light Up With Reynolds American’s High Dividend

Tobacco has long been a controversial industry, yet tobacco companies tend to be some of the steadiest performers in the stock market. Tobacco consumption is not cyclical, and the companies have managed to come up with a plan to maneuver around increased regulation and growing restrictions. Revenues, earnings and dividends are growing at a healthy pace across the industry, and Reynolds American (NYSE:RAI) is one of the leaders.

There’s a peculiar phenomenon across the whole tobacco industry where volumes — particularly in the U.S. — tend to decline while operational performance does not. This is because tobacco companies tend to aggressively hike prices and fight for market share while looking to expand internationally.

Reynolds runs a profitable business — 29.48% operating margins and 19.98% return on equity — that will be rewarding to shareholders for decades. The company has net debt of only $1.66 billion ($2.01 billion in cash with $3.67 billion in total debt), while it generates over $1.11 billion of operating cash flow per year. Reynolds increased the dividend by 8.2% during the first quarter and is committed to further cost-cuts and dividend hikes. The shares currently yield 5.4% based on the new payout.

The five-year average dividend yield for Reynolds American is 6.2%, which puts the current dividend yield in line with the historical range. But five years ago, the 10-year Treasury note was yielding 4.8%, while in late summer of 2011 its yield fell to 1.7%. Shares of companies with high dividends tend to see increased investor interest in a falling interest rate environment, which is great for Reynolds. As the Federal Reserve (repeatedly) intervenes in the bond market to suppress yields of various types of bonds, dividend stocks could see even more investor interest due to the built-in ability to hike dividends if/when inflationary pressures rise.

The stable cash-generating business is perfect for a high dividend payout of 91%. The number looks to be alarmingly high, but the company has hiked the quarterly dividend from 19.4 cents (adjusted for splits) to the current rate of 70 cents in the past 10 years. As profitability grows with a more rapid expansion in emerging markets and better management of the issues in developed markets, Reynolds may have the ability to keep increasing its dividend.

The major players of the U.S. tobacco industry remain less of an “earnings growth” and more of a “free cash flow and dividends” story.  Fat profit margins, good domestic cost controls and growth in emerging markets — where U.S. cigarettes are a status symbol — could bring steady returns to shareholders for many years.

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