Yes, The Dividend At Reynolds American Is Safe

| About: Reynolds American, (RAI)
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In 2012, Reynolds American ran into trouble when its dividend payouts exceeded its profits per share.

In the past two years, the company has used price increases and share buybacks to reduce the dividend payout ratio to 79%.

The stock does have risks, however, as it heavily relies on menthol sales, and the acquisition of Lorillard will only increase Reynolds' reliance on menthol brands.

It was not that long ago that Reynolds American (NYSE:RAI) shareholders found themselves in the position of owning a stock that was paying out more in dividends than it was generating in profits. This is a common problem for shareholders who own stock in a company that deliberately maintains a high dividend payout ratio. In 2011, Reynolds American paid out $2.15 in dividends, while generating $2.81 in profits, for a dividend payout ratio of 76.5%.

Things took a difficult turn in 2012, when Reynolds' Board decided to raise the dividend to $2.33 as profits simultaneously fell to $2.24 per share. It was the first time since 2003 that Reynolds American was paying out more in dividends than it was making in profits. When this happened, the company took on debt to repurchase stock to reduce the share count from 576 million to 530 million (the debt burden now stands at a little over $5 billion, or 52% of the total capital at Reynolds American).

The reduced share count, plus increased price hikes in the 7%-11% range for the Camel, Winston, Pall Mall, Salem, Kool, and Doral brands have helped Reynolds American grow its profits per share from $2.24 in 2012 to $3.40 today. The success of these price hikes, combined with the share buybacks enabled Reynolds to remedy the situation of paying out more in dividends than it was making in profits. As we close out 2014, Reynolds now has a $2.68 annual dividend payout, in comparison to $3.40 per share in profits. The improved business performance, mixed with the financial engineering of the balance sheet, enabled Reynolds American to lower its dividend payout ratio from north of 100% to a much more stable 79% today.

Despite significant improvements in the company's dividend payout ratio over the past two years, there is still one concern to monitor: The FDA is currently engaging in a lengthy review of the health effects and addiction susceptibilities that surround menthol cigarettes. This is something that remains a significant risk for shareholders of Reynolds American, because over 62% of the company's profits originate from menthols.

The commentary regarding the FDA investigation in the financial community has been along the lines of, "There is no way there will be a total ban of menthols." While I agree on that point, there is a greater range of possible outcomes beyond the FDA doing nothing or instituting an all-out ban on menthols. New taxes and/or additional regulations that have not yet been spelled out are possible, and shareholders have to make peace with this unknown risk of what could potentially happen.

I do have one other concern about Reynolds: Most people have been touting the benefits of the merger with Lorillard (NYSE:LO) that is set to take place during the first half of 2015. The common statistic that has been uttered about the Lorillard merger is: "The new Reynolds American will control a third of the domestic tobacco market." When financial analysts bandy about this statistic, they oversell the diversification benefits that come with the Lorillard merger.

When you study Lorillard's balance sheet, you will see that 88% of its profits come from the Newport brand. Sure, the company has promising leads in the vapor/e-cigarette markets, and I do fully expect that Reynolds American will benefit from the growth opportunities that exist beyond traditional cigarettes. However, when you study Lorillard as it is right now, it is essentially Newport. It would be more honest if the company called itself Newport rather than Lorillard, because that would give you a more accurate picture of what Reynolds American is acquiring.

To illustrate, Reynolds generates $1.8 billion in net profits. Lorillard, meanwhile, generates $1.2 billion in net profits. Of that $1.2 billion, about $1.05 billion comes from Newport. The combined company would generate $3 billion in net profits (still below the $5 billion generated at Altria (NYSE:MO)), with over a third of the profits coming from Newport alone. This is an important consideration to keep in mind, because the Reynolds-Lorillard merger actually increases Reynolds' reliance on menthols for the time being. While the merger makes Reynolds more robust, it does not add meaningful diversification to the company's operations.

Despite these reasonable concerns, the dividend at Reynolds American does appear to be safe for the foreseeable future. The payout ratio has come down over twenty percentage points in the past two years, and the company could deal with volume losses among menthols and still keep profits steady as it repurchases about 15 million shares of stock per year. If the Lorillard acquisition goes through, the dividend will receive an added buffer, as the profits per share would increase to $4.50 by the end of 2015. Compared to the current dividend obligation of $2.68 per share, that would temporarily lower the payout ratio to 59.5% and give Reynolds some wiggle room if it has to endure another year like 2012, when profits per share fall.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.