For many years, the tobacco sector has been a great source of high-yield dividend stocks. This might come as a surprise, given how smoking is on the decline in the United States. In addition, an increasing level of public and regulatory scrutiny of Big Tobacco might scare away investors.
But for those solely concerned with generating high-yield dividend income, there are few better places to look than the tobacco industry.
The reason for this is fairly straightforward. Tobacco companies spend very little on capital expenditures, since their processing facilities and distribution systems provide a great deal of scale.
Tobacco companies also enjoy tremendous pricing power, which keeps revenue intact even in an environment of declining smoking volumes. This results in low costs, which allows for high free cash flow, even though revenues are stagnating across the industry.
In fact, the extremely sound economics of tobacco got the attention of none other than Warren Buffett, the world’s most famous investor. In the book “Barbarians at the Gate,” Buffett is quoted as saying, “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”
Indeed. Altria Group (NYSE: MO), maker of the Philip Morris brands like Marlboro and Virginia Slims, generated $4.6 billion in operating cash flow last year and spent just $163 million in capital expenditures. As a result, the company generated $4.5 billion of free cash flow, and since it spends so little, returns on invested capital are always high.
Likewise, one of Altria’s top competitors, Lorillard (NYSE: LO), which manufactures the Newport and Kent brands, generated $1.3 billion of operating cash flow in 2014. Its capital expenditures totaled just $41 million in the same period.
It’s true that smoking is on the decline. Altria stated that cigarette shipments fell by 3.5% last year, continuing a long-term trend of consistent volume declines. To help make up for this, tobacco companies pass through regular price increases to keep revenues from falling.
For example, Altria’s revenue, net of excise taxes per 1,000 units, grew 4.4% compounded annually between 2009 and 2014. This demonstrates the pricing power that tobacco companies enjoy, thanks to the addictive nature of the product they sell. Cigarettes are an inelastic good, meaning demand remains resilient, even in the face of rising prices.
Because of this, both Altria and Lorillard are able to pass almost all of their cash flow through to investors as dividends. Altria and Lorillard paid $3.8 billion and $889 million in dividends last year, respectively. Altria distributed 86% of its free cash flow in 2014, while Lorillard’s free cash flow payout ratio was 69%. There’s little reason for tobacco companies not to distribute the vast majority of their free cash flow, since the business model does not require significant capital investment.
That’s why tobacco companies routinely offer sky-high dividend yields. Altria and Lorillard yield 4%, which is well above the stock market average, and their yields are even higher than many fixed-income securities.
Altria, in particular, is one of the most legendary dividend stocks of all time. The company has increased its dividend 48 times in the last 45 years.
For investors who don’t mind venturing into “sin” stocks, the tobacco industry is a haven for high-yield income seekers, thanks to strong cash flow and high dividends across the sector.
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