Altria And Lorillard Are 2 Top Picks For Income Investors

 |  Includes: LO, MO, RAI
by: Anthony Parsons


Altria just raised its dividend by 8.3% and is poised to have many more dividend increases in the future.

Lorillard is poised to raise its dividend again and offers additional value related to the Reynolds American merger.

These top tobacco stocks have the ability to produce generous returns for shareholders.

For income investors, a good thing to do is to constantly seek out companies that pay generous dividends. Equally important along with doing that is to find companies that have the ability not only to maintain their dividends, but also that can consistently increase their dividends over the years. For purposes of this article, today we will look at Altria (NYSE:MO) and Lorillard (NYSE:LO), both of which represent my top two picks in the tobacco sector and are among the best dividend-paying companies in the world to own shares of, in my opinion.

Altria is the top tobacco company in the United States by market share, and is the owner of the famous Marlboro brand of cigarettes. Altria also owns a 26.8% stake in SABMiller, a top brewing company. Altria has also begun its national rollout of the MarkTen brand e-cigarettes. These factors contribute to its ability to continually increase dividends in the years to come.

Altria just recently raised its dividend by 8.3% and now pays a quarterly dividend of .52 per share, or $2.08 per year. This gives Altria a current dividend yield of 4.86% based on its 8/25/14 closing share price of $42.77. If the company can maintain even a 5% annual dividend increase over the next 5 years, the yield on cost of an investment in Altria today can provide a healthy stream of income that will grow over time.

To illustrate the power of increasing dividends with Altria, and what a purchase at current price levels today could bring, let's look at recent dividend increases by the company. In September of 2010, it raised its dividend to .38 per share per quarter. 2011 brought an increase in the quarterly dividend to .41, 2012 increased it to .44, 2013 upped it to .48, and most recently it was increased this year to .52.

Based on its recent history and even longer history of annual dividend increases, for purposes of this article we will assume that the next dividend increases over the following 5 years will be .04 per quarterly payout, per year. If we multiply that out by 5 years, we arrive at a quarterly dividend that is .20 higher in 5 years than it is today. I believe that to be a conservative estimate because as the dividend rises, a .04 increase in the quarterly amount nets a smaller percentage increase than its recent history has provided.

With a 2.08 annual dividend as it stands now, a .04 per share quarterly increase would bring us to an annual dividend of $2.88 per share in 5 years. (.04*4*5=.80). Based on the closing price of Altria on 8/27/2014, the yield on the cost of buying shares today if those dividend increases come to fruition would be 6.73%. ($2.88/$42.80) With the introduction of MarkTen e-cigarettes, along with the generous share buybacks and earnings potential of the future, the company is in a strong position to be able to achieve this. Share buybacks reduce the number of shares outstanding while also driving the market price up with the buys, and the effect of a reduced number of shares outstanding produces a higher earnings per share amount even if the total earnings remain the same.

Lorillard is in the process of being purchased by Reynolds American (NYSE:RAI) and offers shareholders enhanced value at current price levels because of this, which will be discussed in coming paragraphs. It owns the Newport brand of cigarettes, which dominates the menthol category in the U.S. as it has the largest market share for menthol cigarettes. It also owns Blu brand e-cigarettes, which currently enjoys the largest market share for e-cigarettes.

Lorillard currently pays a dividend of .615 per share for a yearly dividend of $2.46. That gives it a current yield of 4.1%. Keep in mind, Lorillard typically increases its dividend early in a calendar year, so its next dividend increase as a stand-alone company (if applicable) should come well before Altria's.

The real excitement for income investors, as I see it, is the merger with Reynolds American. For this reason alone, I would purchase stock of Lorillard and not Reynolds American because I believe the former offers a generous opportunity for capital gains and income based on current price levels.

The buyout of Lorillard is valued at $68.88 per share, comprised of $50.50 in cash and .2909 shares of Reynolds per share owned of Lorillard at the time of closing. Based on the closing price of Lorillard on 8/25/14 ($60.41), if we subtract out the $50.50 in cash due to be received, we arrive at a $9.91 cost for .2909 shares of Reynolds. Keep in mind, we are not counting brokerage commissions in this example, which are deemed to be immaterial for purposes of this calculation. Based on the 8/25/14 closing price for Reynolds, .2909 shares are worth ($58.23*.2909) $16.94. With Reynolds' current dividend yield of 4.8%, that gives us a 4.8% dividend on $16.94 worth of shares, or .813 per year. Applying that dividend to the previously discussed $9.91 cost, this gives us a staggering 8.2% dividend yield.

I believe the market is extremely overestimating the risk that this deal will not be approved. This risk, in my opinion, is largely mitigated by the fact that Lorillard is dependent on the menthol category for its earnings. While it is making efforts to diversify, without the menthol category, its earnings would tumble. Many efforts have been made to further regulate and/or ban menthol cigarettes, and such actions would be detrimental to the company and to shareholders. A merger with Reynolds would allow Lorillard to achieve much-needed diversification in types of cigarettes.

Another reason that I believe supports legislative approval for the merger is that the combined company will still have to compete with Altria for a large market share. Altria would still have about half of the market share in the United States, which is what the company claims to have on its website. As a result, there would not be upward pressure on consumer prices because of the merger. If Reynolds tried to raise prices too much, smokers would flock to Marlboro cigarettes especially considering that Marlboro is the most recognizable brand of cigarettes in the world.

In conclusion, based on the factors discussed here, these two companies are top choices for income investors seeking sustainable and increasing dividends over the long term. While risk remains that smoking rates will continue to decline, these companies have proven to be able to continually grow earnings. E-cigarettes will provide a new avenue for earnings growth, and it has the potential to create a new market. Between smokers quitting traditional cigarettes for e-cigarettes, new smokers who would only want to smoke an e-cigarette, and people who will smoke both kinds of cigarettes, I estimate that revenues for the companies will continue to climb in the mid single digits over the next 5-10 years. This does not even factor in a potential nationwide legalization of pot, which could provide the potential to grow revenues and earnings significantly more.

As always, please do your own research and conduct your own due diligence before buying any stock.

Disclosure: The author is long LO, MO, RAI.

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.