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Summary

  • Average annual growth of about 8% in dividends.
  • The high payout ratio based on free cash flows is due to an abnormally high increase in the working capital.
  • Increasing volume of cigarettes shipped indicates the profitability will be enhanced.

The tobacco industry has some of the highest-yielding stocks in the market, with an industry average of 4.6%. As a result, the tobacco industry cannot be overlooked when making a decision to pick some investments for income. Reynolds American (NYSE:RAI) is one of the biggest players in the industry, with a dividend yield of about 5%.

Reynolds American is a holding company, with its affiliates and subsidiaries involved in the manufacturing and sales of cigarettes and other reduced-risk products in the U.S. In this article, we will look at the dividends, growth in dividends and the future prospects of the company in the tight socio-political situation of the tobacco industry.

Dividend Growth

Reynolds has been growing its dividends on a consistent basis, and the company has grown its dividends at an average annual growth rate of about 8% since 2009. At the moment, the company pays an annual dividend of $2.68 per share, yielding 5%. During the last year, Reynolds distributed cash dividends of $1.34 billion. Furthermore, the company repurchased shares worth $775 million, which means the total cash returned to shareholders was $2.12 billion in the last year.

The payout ratio based on free cash flows is very high for Reynolds. The total dividends paid for the last year stood at $1.34 billion, and free cash flows for the same period were $1.15 billion, which puts the payout ratio of Reynolds at around 116%. The high payout ratio is due to the increased capital spending and reduced cash flows from operations over the last year. At a glance, the situation looks precarious for the company; however, the reason behind reduced operating cash flows was not the deterioration in the business of the company, instead, it was due to a one-time abnormally high increase in the working capital. The payout ratio based on earnings, however, is close to 78%.

Reynolds has increased the capital expenditures by 74% in the last year. However, the company has reduced its capital spending guidance by approximately 30%-47% for 2014, which will free enough cash flows to increase the dividend payout. Despite a high payout ratio, the company has been able to grow its dividends at a decent rate over the last five years.

Dividend per Share

Average Growth in five Years

Free Cash Flows (Billions)

Cash Dividends (Billions)

Payout Ratio

Reynolds

$2.48

8%

$1.15

$1.34

116%

Altria Group

$1.84

13%

$4.25

$3.6

85%

Lorillard

$2.2

16%

$1.13

$0.8

71%

Source: Morningstar

It is clear from the table that Reynolds falls behind its peers when it comes to dividend growth. Lorillard (NYSE:LO) and Altria Group (NYSE:MO) have grown dividends at a much higher rate than Reynolds American over the last five years. The reduced CapEx guidance for the current year will boost the free cash flows, eventually bringing the payout ratio to an optimum level with more room to grow its dividends.

Future Prospects

Due to increasing regulation and consumer health-consciousness, the environment is becoming less favorable for the tobacco industry. The profitability of the U.S. cigarette industry is adversely affected by the decrease in consumption, increases in state excise taxes and government regulations and restrictions. However, Reynolds' tobacco cigarette portfolio consists some of the bestselling brands in the U.S., such as Camel and Pall Mall. These brands continue to contribute towards the profitability of the company. The company has also increased its domestic cigarette shipment volumes over the last year, with a retail market share of 26% of the U.S cigarette market.

In order to survive in the tight socio-political environment, the leading tobacco companies are opting for technological changes in their product lines in order to introduce reduced-risk products, which include hybrid and electronic cigarettes. Reynolds American has also followed the change and introduced smokeless tobacco products in the U.S. through its subsidiary, American Snuff. As the second-largest smokeless tobacco products manufacturer, the company offers a wide range of differentiated reduced-risk products to its customers. Moreover, in contrast to the declining U.S cigarette market, the company grew its retail volumes by around 5% in the last year. This will benefit Reynolds American's shifting interest in the reduced-risk products business, and enable the company to reap considerable benefits in the future.

Conclusion

The increased awareness has affected the tobacco industry, growing the consumer sensitivity. Therefore, the future growth prospects of these companies have been questioned. However, despite all these issues, Reynolds American has been able to grow its dividends at a decent rate and generate solid free cash flows. In my opinion, the company's shifted focus towards reduced-risk products will continue to grow its revenue and enable the company to generate impressive growth in its dividends.

Source: Is Reynolds American A Good Dividend Stock?