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Dividend growth investing is lots of fun, especially if you have a systematic methodology to determining which companies' dividends are safe and which ones' aren't. That is why we created a forward-looking assessment of dividend safety in our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. In this article, let's evaluate the investment merits of Reynolds American (NYSE:RAI), as well as its dividend under this unique but yet very straightforward framework.

Investment Considerations

Structure of the Tobacco Industry

The oligopolistic tobacco industry is attractive in a number of ways. Firms sell an "addictive" product (cigarettes and/or smokeless tobacco), have significant pricing power, generate high margins, and strong returns on invested capital. Still, declining trends in smoking in the US, threats of tobacco-related litigation, new tobacco regulation (labeling) that discourages tobacco use, and excise tax price shocks that may impact demand will always be concerns. Still, we tend to like the structural characteristics of the tobacco industry and the shareholder-friendly policies of constituents.

Return on Invested Capital

Reynolds American's Dividend

Reynolds American's dividend yield is above average, offering just below a 5.5% annual payout at recent price levels. We prefer yields above 3%, and don't include firms with yields below 2% in our dividend growth portfolio.

We think the safety of Reynolds American's dividend is good (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges (read hiccups in operations), which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future.

For Reynolds American, this score is 1.3, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (NYSE:WMT) scores a 1.4 on this measure. Also, for firms that have a score below 1 or that have a negative score, the risk of a dividend cut in the future is certainly elevated. In fact, the Valuentum Dividend Cushion caught all dividend cuts in our non-financial coverage universe, except for one, which subsequently raised its dividend above pre-cut levels (meaning it shouldn't have cut it in the first place). The Dividend Cushion also caught the recent cuts by JC Penney (NYSE:JCP) and SuperValu (NYSE:SVU). We use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter (please see our links on the left sidebar for more information).

Now on to the potential growth of Reynolds American's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is not the case for Reynolds American's. We rate the firm's future potential dividend growth as good. Though the company generates sufficient cash-flow capacity to cover its dividend, the spread above parity is not as large as other firms. Still, we like it.

And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Reynolds American's case, we think the shares are fairly valued, so the risk of capital loss medium. If we thought the shares were undervalued, the risk of capital loss would be low.

All in all, we're strongly consider adding Reynolds American to our dividend growth portfolio. The company has an outsize yield, and the growth prospects of the payout remain sound.

Source: Why Reynolds American's Dividend Cushion Is Solid