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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 priceEPSDividendYieldDividend Cover
$120$8$65.09%1.4

Cash Flow Statement

$US millions201020119 Months to September 2012
Net Operating Cash Flow10901180641
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)987741494
Net Financing Cash Flow-372-156016
Free Cash Flow406404503
Free Cash Flow ex. debt issuance-311-11769

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 priceEPSDividendYieldDividend Cover
$33$2.1$1.75.12%1.2

Cash Flow Statement

Altria
$US MILLIONS201020119 Months to September 2012
Net Operating Cash Flow277036102130
Net Investing Cash Flow259387728
0
Cash Dividends Paid - Total-2960-3220-2508
Repurchase of Common & Preferred Stk.98-1320-595
Issuance of long term debt (Reduction)2321490165
Net Financing Cash Flow-2580-3040-3939
Free Cash Flow449957-1081
Free Cash Flow ex debt issuance217-533-1246

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 priceEPSDividendYieldDividend Cover
$43$3$25.42%1.2

Cash Flow Statement

$US MILLIONs201020119 Months to September 2012
Net Operating Cash Flow12701420907
Net Investing Cash Flow-43360-26
0
Cash Dividends Paid - Total
-1050
-1210-977
Repurchase of Common & Preferred Stk.-5-282-851
Issuance of long term debt (Reduction)(300)(400)0
Net Financing Cash Flow
-1355

-1892

-1598
Free Cash Flow518-412-717
Free Cash Flow ex debt buyback818-12-717

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 priceEPSDividendYieldDividend Cover
$90$5$33.67%1.6

Cash Flow Statement

Philip Morris International
$US MILLIONs201020119 Months to September 2012
Net Operating Cash Flow944010537770
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)93820603912
Net Financing Cash Flow-8580-8340-4893
Free Cash Flow150-83172186
Free Cash Flow ex debt issuance-788-6257

-1726

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.

Source: How Safe Are Tobacco Yields?