Is Reynolds American's Dividend Safe?

 |  About: Reynolds American, Inc. (RAI)
by: Bennington Investment Ideas

Reynolds American, Inc. (NYSE: RAI) is a leading tobacco company that manufactures and sells cigarettes and other tobacco products throughout the United States. Over the past 12 weeks, RAI has declined just 2.4%, relative to a 4.5% decline for the tobacco industry and a 16% decline for the S&P 500.

RAI Dividend Characterized By High Payout Ratios

RAI had about $8.9 billion in revenue with $1.1 billion in net income in 2010. RAI has a market capitalization of $21.9 billion and an enterprise value of $24.2 billion, suggesting limited leverage. RAI has a strong track record of paying dividends. However, for 2010, its payout ratio to net income was 94% and its payout to operating cash flow was 83%. These are pretty high figures suggesting that it might be difficult to grow the dividend without underlying growth. Some recent dips in net income further complicate the picture.

Historical Dividend Growth Has Been Inconsistent

RAI's estimated forward dividend yield is 5.7% based upon a closing price of $37.48 and the author's projected annual dividend of $2.15. The following table shows the estimated forward quarterly dividends as well as the recent historical quarterly dividends. RAI does not have a consistent record of regular growth as noted in the table below.

Historical and Projected Dividends

Type Ex-Dividend Date Quarterly Dividend ($ per share) Change on prior year
Projected 9/8/2012 0.540 1.9%
Projected 6/8/2012 0.540 1.9%
Projected 3/8/2012 0.540 1.9%
Projected 12/8/2011 0.530 8.2%
Historical 9/8/2011 0.530 17.8%
Historical 6/8/2011 0.530 17.8%
Historical 3/8/2011 0.530 17.8%
Historical 12/8/2010 0.490 8.9%
Historical 9/8/2010 0.450 5.9%
Historical 6/8/2010 0.450 5.9%
Historical 3/8/2010 0.450 5.9%
Historical 12/8/2009 0.450 5.9%
Historical 9/8/2009 0.425 0.0%
Historical 6/8/2009 0.425 0.0%
Historical 3/6/2009 0.425 0.0%
Historical 12/11/2008 0.425 0.0%
Historical 9/8/2008 0.425 0.0%
Historical 6/6/2008 0.425 13.3%
Historical 3/6/2008 0.425 13.3%
Historical 12/7/2007 0.425 13.3%
Historical 9/6/2007 0.425 13.3%
Historical 6/7/2007 0.375 20.0%
Historical 3/13/2007 0.375 20.0%
Historical 12/7/2006 0.375 20.0%
Historical 9/7/2006 0.375 42.9%
Historical 6/7/2006 0.313 31.6%
Click to enlarge

Source: Author estimates, Yahoo!Finance

The following graph shows the historical trailing twelve month yield and spread to the 10-year Treasury bond.

Created from data from Yahoo!Finance

RAI had a massive spike in yield due to significant drop in stock price. The spike is very exaggerated in this graph since I use point estimates based on ex-dividend dates and RAI's ex-dividend date was March 6, 2009 which was almost the exact same date has the market lows. In comparison, the S&P 500 closed at 683 on March 6, 2009. The next graph shows the normalized performance of the stock price, the dividend, and the trailing dividend yield.

Created from data from Yahoo!Finance

Long Term Growth Issues Create Valuation Uncertainty

The first step to using the dividend discount model is to calculate an equity hurdle rate with the Capital Asset Pricing Model. RAI has a beta of .67 and with the risk free rate at a very low 1.9% this gives the discount rate to be a 6.6%. As noted above the forward dividend is approximately $2.15. Applying a long term growth rate of 2% gives an estimated price of $48.59 for RAI. This is approximately a 30% premium to the current price of $37.48. However, as with any dividend discount model, the result is highly sensitive to growth rate and equity hurdle rate assumptions. Furthermore, with the variable dividend growth rates in RAI's history and the high payout ratios, this is even more critical.

Dividend Discount Model Sensitivities

Sensitivity Equity Hurdle Rate
Growth Rate 5.6% 6.6% 7.6% 8.6%
-2.0% 29.43 26.02 23.31 21.11
-1.0% 33.89 29.43 26.02 23.31
0.0% 39.93 33.89 29.43 26.02
1.0% 48.59 39.93 33.89 29.43
2.0% 62.05 48.59 39.93 33.89
3.0% 85.82 62.05 48.59 39.93
Click to enlarge

Source: Author calculations

RAI is an interesting dividend investment opportunity but carries some additional risks since it is essentially focused exclusively on the U.S. markets. Smoking rates had been creeping downward in the United States until 2008. However, population growth has offset a significant portion of the rate decline. More recent results suggest a stabilization in the smoking rate around 20% or about 62 million Americans. While I used a 2% long term growth rate, the sensitivities show that it is close to fair value with a 1% growth rate and over valued at 0% growth. Furthermore, as interest rates rise, some time in the future, investors will demand greater returns. RAI does have some downside protection with an estimated equity liquidation value of $6.7 billion or 75% of the current market equity value.

Disclosure: I am long SPY.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.