Is Reynolds American Or Altria The Best Fit For Your Dividend Portfolio?

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 |  About: Reynolds American, Inc. (RAI), MO
by: Sure Dividend

Summary

See the potential risk/reward of Reynolds American's proposed acquisition of Lorillard.

Altria's second quarter results show continued market share gains.

Reynolds American and Altria both have dividend yields north of 4%.

Altria has paid increasing dividends for 39 consecutive years.

Reynolds American and Altria are two of the largest US cigarette companies based on market cap, market share and sales.

Reynolds American (NYSE:RAI) and Altria (NYSE:MO) are two of the nation's largest cigarette businesses. Reynolds American manufactures and sells Camel, Pall Mall, Natural American Spirit brand cigarettes, as well as Grizzly smokeless (chewing) tobacco and VUSE e-cigarettes. Altria's cigarette brands include Marlboro, Basic, Chesterfield, Virginia Slims and Parliament. The company sells the Copenhagen, Skoal and Husky smokeless (chewing) tobacco brands, Black & Mild personal cigars, and wine under its St. Michelle winery label. In addition, Altria also owns a 27% stake in the SAB Miller brewing company.

Both businesses generate the bulk of their revenues from the declining cigarette industry. The industry is realizing volume declines of about 4% a year due to increased government regulation and greater consumer awareness about the health effects of smoking cigarettes.

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Source: Altria Group CAGNY Conference Presentation

Reynolds American and Altria have both been able to increase their dividend payments to shareholders each year over the last several years despite headwinds in the tobacco industry. We will review Reynolds American and Altria using the 5 Buy Rules from the 8 Rules of Dividend Investing. The 8 Rules of Dividend Investing identifies high quality businesses trading at fair prices or better prices.

The 8 Rules of Dividend Investing works by comparing a company's long history of dividend payments. This type of comparison creates a quantitative way to determine and rank high-quality dividend stocks.

Consecutive Years of Dividend Payments

Reynolds American does not have as long a history of dividend increases as does Altria does. The company has not reduced its dividend payments since 2000. Since 2000, Reynolds American has increased its dividend payments each year, except for 2005, when the dividend payment remained flat from 2004.

Source: Reynolds American Dividend History

Altria has paid increasing dividends for 39 consecutive years, excluding the impact of spin-offs (Philip Morris International and Kraft). The company's long history of dividend payments without a reduction is evidence of corporate stability and a strong competitive advantage that has lasted despite changes in consumer preferences, economic factors, and the overall legislative environment of the tobacco industry.

Source: Altria Dividend History

Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 2.88 percentage points per year.
Source: S&P 500 Dividend Aristocrats Factsheet, February 28 2014, page 2

Dividend Yield

  • Reynolds American has a dividend yield of 4.71%, the 6th highest out of 133
  • Altria has a dividend yield of 4.60%, the 8th highest out of 133

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Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 1.76 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns

Payout Ratio

  • Reynolds American has a payout ratio of 94.70%, the 125th lowest out of 133
  • Altria has a payout ratio of 88.89%, the 120th lowest out of 133

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Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Long-Term Growth Rate

The long-term growth rate of each business is calculated as the lesser of the 10-year per share growth in either dividends or revenue.

  • Reynolds American has a growth rate of 0.59%, the 117th highest out of 133
  • Altria has a growth rate of 5.30%, the 52nd highest out of 133

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Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4 percentage points per year from 1972 to 2013.
Source: Rising Dividends Fund, Oppenheimer, page 4

Long-Term Volatility

Long-term volatility for each business is calculated as the 10-year price standard deviation.

  • Reynolds American has a standard deviation of 21.19%, the 23rd lowest out of 133
  • Altria has a standard deviation of 20.29%, the 21st lowest out of 133

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Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race, page 3

Reynolds American Current Events and Growth Prospects

Reynolds American has announced a potential merger that would transform the business. Reynolds American plans to pay $50.50 in cash and .2909 Reynolds American shares for each Lorillard share. The deal values Lorillard at about $67 per share.

Lorillard currently has a market cap of $22 billion. The proposed transaction values Lorillard at about $24.3 billion based on Reynolds American's current share price. Reynolds American will raise the proceeds to pay for the transaction from the following sources:

  • $0.5 billion from cash on hand
  • $4.4 billion from divestiture proceeds (discussed below)
  • $9.0 billion from new debt
  • $5.9 billion from stock issuance to Lorillard
  • $4.7 billion from British American Tobacco (discussed below)

Divestiture Proceeds

In the proposed transaction, both Reynolds American and Lorillard would sell several of their brands to Imperial Tobacco for $4.4 billion ($7.1 billion pretax). Reynolds American will divest Kool, Salem and Winston. Lorillard will divest Maverick and blu. In addition, Lorillard's operating assets will go to Imperial Tobacco in the transaction.

British American Tobacco Ownership

The proposed deal would see British American Tobacco fund approximately $4.7 billion of the deal in order to maintain its 42% stake in Reynolds American.

Business Advantages of Combination

The proposed merger would create the second largest tobacco company in the US, behind only Altria. The company's portfolio would include the second largest US cigarette brand in Newport, as well as the third largest US cigarette brand in Camel and fourth largest brand in Pall Mall. In addition, the combined business would own American Spirit, Grizzly and Vuse.

The Newport brand is by far the most valuable asset in the Lorillard portfolio. Newport is the number one menthol cigarette brand in the US. It has managed to grow cigarette volume over the last decade despite significant volume declines in the US cigarette industry.

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Source: Reynolds American Lorillard Acquisition Report

The combined business would control over 34% of US cigarette volume (Altria controls over 50% now). Reynolds American operating income would jump from about $3.1 billion to around $4.0 billion without synergies. The company is expecting operating synergies which will result in cost savings of $800 million per year. In total, the combined company expects operating income of $4.8 billion which is over 50% higher than current operating margin for Reynolds American.

Acquisition and Future Growth Prospects

The proposed acquisition will shape the future of Reynolds American. The company has barely managed to grow revenue over the past 10 years. The addition of the Newport brand will help bolster the company's lackluster growth. The acquisition will further be accretive for shareholders by drastically increasing Reynolds American's share of the US cigarette industry in hopes to better compete with Altria.

Altria Current Events and Growth Prospects

Altria delivered solid second quarter results last week. The company reported adjusted EPS growth of 5.2% for the second quarter of 2014 as compared to the second quarter of 2013. Altria expects full year EPS growth of between 7% and 9%.

Altria divides its operations into 3 segments: Smokeable Products, Smokeless Products and Wine. The company's revenue per segment for the second quarter breaks down as follows:

  • Smokeable Products - 87% of revenues net of excise taxes
  • Smokeless Products - 10% of revenues net of excise taxes
  • Wine - 3% of revenues net of excise taxes

Source: Altria 2nd Quarter Earnings Release

Smokeable Products

Net revenues for the company's smokeable product segment net of excise tax increased 0.8% for the second quarter of 2014 compared to the second quarter of 2013. Operating margins increased from 43% to 44.2% due to price increases.

The company's total smokeable product volume declined substantially in the quarter, down 4.8%. The large decrease was in line with overall cigarette industry declines.

Altria increased its market share of the US cigarette industry from 50.7% in the second quarter of 2013 to 51% in the second quarter of 2014. Marlboro is the leading cigarette brand in the US. The brand gained another 0.3% of market share in the most recent quarter. Marlboro's market share has been increasing for decades.

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Source: Altria Annual Presentation

Smokeless Products

Altria's smokeless category generates the bulk of its revenue from the Copenhagen and Skoal brands. Revenue net of excise tax increased 0.7%, and operating margins increased from 63.5% to 66.6% for the second quarter of 2014 compared to the second quarter of 2013.

In sharp contrast to the smokeable segment, smokeless product volume increased 1.6% in the quarter. Altria grew its overall share of the smokeless tobacco industry from 55% in the second quarter of 2013 to 55.1% for the second quarter of 2014. Copenhagen market share increased by 1.5 percentage points, while Skoal market share fell 1.1 percentage points.

Wine

Altria's wine segment accounts for only 3% of revenues, but is the company's fastest growing segment. Revenue net of excise tax increased 6.8% for the 2nd quarter of 2014 as compared to the second quarter of 2013. Operating margins increased from 18.9% in the second quarter of 2013, to 19.9% this quarter. Overall, operating income grew a strong 12% for the segment.

e-Vapor

Altria is continuing to invest heavily in e-Vapor growth. The company's MarkTen e-vapor products began its national expansion. MarkTen is currently in 60,000 retail stores in the Western half of the US. Altria completed the acquisition of Green Smoke in the second quarter, and expects to integrate Green Smoke into its business operations throughout the year.

Final Thoughts

Reynolds American and Altria both compete in the declining US cigarette industry. Both companies' strong brands have resulted in strong pricing power which is allowed both companies to reward shareholders with continuously increasing dividend payments. The proposed acquisition of Lorillard by Reynolds American will change the competitive landscape of the tobacco industry if shareholders and the government approve of the deal.

The 8 Rules of Dividend Investing ranks Altria as the 17th best buy out of 132 business with 25-plus years of dividend payments without a reduction. Altria's high payout ratio means the company cannot increase dividends faster than overall growth for the foreseeable future, and is the reason the stock does not rank higher based on the 8 Rules of Dividend Investing.

Reynolds American is not a Sure Dividend stock as it does not have 25-plus years of dividend payments without a reduction. If it did, it would have only a below average rank due to its low growth rate and extremely high payout ratio, which is partially offset by the company's low volatility and high payout ratio.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.