How Safe Are Tobacco Yields?

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 |  Includes: MO, PM, RAI
by: Rupert Hargreaves

In today's environment of low interest rates, investors are left looking elsewhere for decent returns on their money. One of the consistently highest yielding sectors in the market is tobacco. With the average tobacco yield now around 5%, how sustainable are these yields? The business of tobacco is no longer what it used to be, with opinions changing and companies seeing falling volumes. However, companies are still raising shareholder returns.

How sustainable are these returns for the long term and can small and large investors rely on these firms to keep the cash flowing?

1. Lorillard (NYSE:LO)

Overview

2012 EST.
Share price EPS Dividend Yield Dividend Cover
$120 $8 $6 5.09% 1.4
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Cash Flow Statement

$US millions 2010 2011 9 Months to September 2012
Net Operating Cash Flow 1090 1180 641
Net Investing Cash Flow -40 -50 -154
Cash Dividends Paid - Total -645 -726 -204
Repurchase of Common & Preferred Stk. -716 -1580 -274
Issuance of long term debt (Reduction) 987 741 494
Net Financing Cash Flow -372 -1560 16
Free Cash Flow 406 404 503
Free Cash Flow ex. debt issuance -311 -1176 9
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The overview of Lorillard looks ok. The dividend is covered but only just. Looking into the cash flow of LO the dividend payout is well covered. However, the stock buyback the company is undertaking to improve EPS, is pushing the firm to issue new debt to cover these buybacks.

2. Altria (NYSE:MO)

Overview

2012 EST.
Share price EPS Dividend Yield Dividend Cover
$33 $2.1 $1.7 5.12% 1.2
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Cash Flow Statement

Altria
$US MILLIONS 2010 2011 9 Months to September 2012
Net Operating Cash Flow 2770 3610 2130
Net Investing Cash Flow 259 387 728
0
Cash Dividends Paid - Total -2960 -3220 -2508
Repurchase of Common & Preferred Stk. 98 -1320 -595
Issuance of long term debt (Reduction) 232 1490 165
Net Financing Cash Flow -2580 -3040 -3939
Free Cash Flow 449 957 -1081
Free Cash Flow ex debt issuance 217 -533 -1246
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Altria is paying out most of its EPS as dividends to shareholders. Combined with the stock repurchases, this is making the most of Altria's cash flow negative.

3. Reynolds American (NYSE:RAI)

Overview

2012 EST.
Share price EPS Dividend Yield Dividend Cover
$43 $3 $2 5.42% 1.2
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Cash Flow Statement

$US MILLIONs 2010 2011 9 Months to September 2012
Net Operating Cash Flow 1270 1420 907
Net Investing Cash Flow -433 60 -26
0
Cash Dividends Paid - Total
-1050
Click to enlarge
-1210 -977
Repurchase of Common & Preferred Stk. -5 -282 -851
Issuance of long term debt (Reduction) (300) (400) 0
Net Financing Cash Flow
-1355
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-1892

-1598
Free Cash Flow 518 -412 -717
Free Cash Flow ex debt buyback 818 -12 -717
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Once again RAI is only just covering its dividend from EPS. However, it has been buying back debt rather than issuing it. Still, cash flow is coming under pressure.

Philip Morris International (NYSE:PM)

Overview

2012 EST.
Share price EPS Dividend Yield Dividend Cover
$90 $5 $3 3.67% 1.6
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Cash Flow Statement

Philip Morris International
$US MILLIONs 2010 2011 9 Months to September 2012
Net Operating Cash Flow 9440 1053 7770
Net Investing Cash Flow -710 -1030 -691
0
Cash Dividends Paid - Total -4420 -4790 -3980
Repurchase of Common & Preferred Stk. -4800 -5300 -3210
Issuance of long term debt (Reduction) 938 2060 3912
Net Financing Cash Flow -8580 -8340 -4893
Free Cash Flow 150 -8317 2186
Free Cash Flow ex debt issuance -788 -6257

-1726

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PM has the best dividend cover in the group. However, the cash flow statement could be better with high debt issues still needed to cover buybacks and dividends. In fact, debt issuance in 2011 was 200% of net operating cash flow.

The result is that dividends for most firms do seem to be covered through free cash flow, however, stock buy backs are usually not covered and money needs to be borrowed to fund them. This causes a problem for big tobacco, as with falling volumes the tobacco companies need to improve their EPS. The easiest way to do this is to buy back shares.

The conclusion - most dividends look safe for now. However, total shareholder returns could come under significant pressure in the future.

Disclosure: I am long LO, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.