Since Altria (NYSE:MO) and its tobacco peers are major dividend-oriented companies, I felt that it is necessary to show interested investors a deeper dive into the quality of their dividends. Over time, it is without a doubt that the tobacco industry has been consistently been able to pay increasingly higher dividends back to its shareholders while having fabulous capital gains. In my earlier article on Altria, I broke down and determined the company's intrinsic valuation due to its exposure to SABMiller (OTCPK:SBMRY). Overall, if successful, the brewery merger will make for a large impact on Altria's earnings and dividends in the future. Below includes the tobacco industry's year-end share price appreciation and total returns data. It is not surprising that many of the largest players such as Altria and Reynolds American (NYSE:RAI) have produced the highest total share price returns over time (i.e. 5.5Y∆).
When assessing dividends, many investors typically use dividend yield, dividend payout and dividend growth to measure its quality. With many of the companies in the industry having very similar results, it is often difficult to determine which one is going to do better than the other. You might be asking yourself "I mean as long as they are paying a high dividend does it even matter?" Unfortunately it does matter as there are many companies out there that pay very high dividend yields but are paying in excess of what they earn (i.e. they are borrowing money to pay dividends), which is not sustainable in the long run. The best test for a dividend-paying company is to see if its balance sheet management and reinvestment capabilities are strong through its free cash flow generation.
In my previous article related to dividends, I introduced new measures that investors should consider in addition to generally-accepted measures. To summarize, investors should consider dividends relative to a company's free cash flow generation before paying them out. Furthermore, when a company finds it better to do so over dividends, share repurchases are a solid avenue for bringing returns back to shareholders.
Share repurchases are often a good indicator of when a company's management believes that their stock is undervalued and they are willing to buy back their shares from the public. In the most basic sense, having another large buyer in the market can also help drive the buying volume for the company's stock. Many of the shares that are repurchased are used to offset the future exercising of options from company executives instead of diluting from further stock issuances. Also, in some jurisdictions that tax dividends at higher rates than capital gains, share repurchases have a tax advantage over cash dividends in providing returns to shareholders. On the downside, share purchases naturally increase the leverage on the balance sheet as show below:
For share repurchases, I introduced the "Shareholder return" measure which is simply the total dividends paid plus the amount used for share repurchases. Although share repurchases are not as material as the cash dividends that we receive in the mail, it is ultimately built into the share price appreciation. Below includes the concepts that I introduced:
= Dividends + Share Repurchases
A company's direct returns back to shareholders is through dividends and share repurchases.
Payout to FCF %
= Dividends / FCF
The proportion of FCF given as dividends after reinvesting back into its company via capex.
Net Repurchases Yield %
= (Share Repurchases - Issuances) / Stock Price
The return to shareholders that are from a company's efforts to repurchase its shares. It can be thought of similar to the dividend yield.
Shareholder Yield %
= Dividend Yield % + Net Repurchases Yield %
The total return to shareholders as a result of dividends paid and shares repurchased in the period.
Shareholder Return to Earnings Payout %
= Shareholder Return / Net Income
The proportion of Net Income that is being used to pay back to shareholders.
Shareholder Return to FCF Payout %
= Shareholder Return / FCF
The proportion of FCF used for shareholders returns after reinvesting back into the business.
Over time, Altria and its peers have paid significant amounts of dividends back to its shareholders. In addition to the dividend, the companies have generated returns to shareholders from its significant share repurchases. When combing the amount that companies pay back to shareholders through dividends and share repurchases, it often comes out to be quite significant. On a yield perspective, share repurchases can intrinsically add a significant amount to the total returns. In Altria's perspective where its dividend yield is currently 3.4%, the amount of share repurchases theoretically increases it to 3.8% (Shareholder Yield %). In the most basic sense, if the company decided not to do share repurchases but use those funds as dividends instead, the overall dividend yield would be higher. In contrast, if a company issues more shares instead of repurchasing them, then it would dilute ownership and theoretically be a reduction to dividend yield.
An observation from the exhibit below is that amount used for share repurchases have gradually decreased over time for all companies in the industry. This may possibly infer that tobacco valuations are not as attractive as they have been in the past and thus management would prefer increasing dividend payouts instead. In terms of a shareholder yield basis, many companies lately have not been engaged in many material share repurchase activities as they have been in the past. As a result, we get dividends yields that are very close to the shareholder yields.
Free Cash Flow Payout
As mentioned before, companies that pay dividends should be tested by their free cash flow generation. Free cash flows ultimately measure what cash is remaining after the company has reinvested back in their business via capital expenditures. Usually a company will use their free cash flow to pay back their debt or pay their shareholders through dividends or share repurchases. Otherwise they will be keeping the rest of the cash in the corporate bank account. From the exhibit below, with the exception of Reynolds American, all companies are paying their dividends within the means of the free cash flow using the Dividend/FCF Payout % measure. If you don't already know, Reynolds merged with Lorillad (NYSE:LO), hence the FCF and dividend structure has not been solidified yet and has produced wild outcomes on the tables. Hopefully, the dividends and share repurchases will return back to their historical levels.
Based on the two shareholder return payout measures, many of the companies currently pay within the means of what they earn in terms of earnings and free cash flow. What is worth noting from these tables is that the industry has finally reached a stabilized level. Prior to 2015, the entire industry has been paying out to shareholders in excess of what they earned given payouts exceeding 100%. From the Shareholder return to FCF Payout % measure, it simply means that that historically, companies in the industry have been partially financing their dividend and share repurchasing activities.
Arguments against the measures
- Companies have sufficient cash balances to manage their dividends and debt levels
- Although leverage is certainly higher for the industry, the company has had decades of experience in debt management and continues to with dividends and share repurchases
- Companies continue to generate higher earnings and free cash flows every year that can easily cover prior years of excess financing or mismanagement
In conclusion, Tobaccos continue to be one of the stock market's best industries for capital gains and dividend returns to shareholders. When assessing any company's dividend, the quality of the dividend should consider both earnings and free cash flow. Free cash flows consider the cash that is left from operations after reinvesting back into the business first. A company that spends more than their free cash flows on dividends and share repurchases is a clear indicator that it is using other sources of financing to support these activities. In addition to pure dividend returns, investors should also consider share repurchases to determine an intrinsic total shareholder return. Although we may find that some companies provide lower dividend yields than their peers, it is possible this difference is made up from the share repurchases.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MO, RAI over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I used to have a position in MO.
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