Why own any stock if it doesn't pay a dividend? While the S&P 500 and its tracking exchange traded fund, the SPDR S&P 500 ETF (SPY), is up over 25% from the lows of last year, dividend stocks have consistently been the best performing stocks in the market.
Few dividend stocks are more popular than tobacco stocks. While companies such as Procter & Gamble (PG) and AT&T (T) have strong histories of consistent dividend raises, the tobacco industry has delivered strong income and total returns for many years.
The most widely held tobacco stock is Altria.
Altria split from Philip Morris International in 2008, and the company has an impressive history of consistently raising the dividend by high single digits.
Altria has a target payout ratio of 80% and the company has raised its dividend at an average of 8% a year since 2008, well above the consumer price indexes increases over the last five years.
Still, there are strong signs the company's recent dividend raises are unsustainable.
While Altria raised the dividend from 2008 to 2010 with increased earnings, litigation settlements has caused net income to essentially flatline since 2010. Altria's target payout ratio is 80%, but the company has consistently paid out 100% of net income since 2010.
Altria has been able to continue to raise dividend payouts with debt, but the company's cost of capital is over 6% longer-term, and management will need to increasingly service debt payments if the company's cost of capital rises as interest rates rise.
Altria's recent quarterly results were strong, and the company guided for high single digit growth of 7-9% and earnings per share of $2.17-2.20. Still, the company had to recently revise its guidance to $2.01-2.07 after recalling $2 billion in debt.
If interest rates rise even modestly, the company's long-term cost of capital will likely be 8-10%, and the company will need to increasingly service the nearly $14 billion in long-term debt at the expense of the dividend. Altria has been borrowing at historically cheap rates to finance the dividend as a carry trade since the company's short-term borrowing costs have been lower than the yield, but if rates rise even modestly the company will likely increasingly have to service debt payments at the expense of the dividend.
To conclude, analysts are projecting the U.S.'s biggest tobacco company to grow at a high single digit rate over the next several years, but Altria has over 50% of the U.S. tobacco market, and the company's significant cost savings initiatives have been completed. The company's volumes continue to decline each year as well. Altria's recent dividend raises appear impressive, but companies will not be able to rely on cheap capital longer-term. If rates rise even modestly, management will likely be forced to increasingly focus capital on the company's significant long-term debt, and future dividend raises should be 5% or less. While tobacco stocks have been some of the strongest performing dividend stocks in the market for some time, past performance is not always indicative of future results.