Why Big Dividend Growth Awaits Reynolds American

Reynolds American tobacco has officially acquired Lorillard and now owns Newport, one of the strongest brands in the tobacco sector that has industry leading profits in the menthol sector and has maintained volume shipments even while the tobacco-smoking industry as a whole shrinks by 3.5% annually in the United States.

The addition of Newport has greatly increasing the per share earnings power of the company even after adjusting for dilution resulting from the acquisition. Before the transaction, Reynolds had 530 million shares outstanding and was earning $2.70 per share, or $1.4 billion in net profits.

Now that Reynolds has ownership of Newport (which accounted for 88% of Lorillard’s 2014 sales) and the remaining 12% of the Lorillard portfolio, the expected profits for Reynolds American is $4.15 per share, or $2.6 billion in net profits spread across 715 million shares.

This is what catches my attention: For most of the past generation, Reynolds American has maintained a dividend payout ratio between 70% and 80%. The current dividend is $2.68. Compared to last year’s profits of $2.70, that is a dividend payout ratio of 99%. But now that Lorillard is on board, the dividend payout ratio is only 64.5%.

Prior to the acquisition, Reynolds had a ten-year track record of growing earnings per share by 9.5% annually.The dividend went up by 6% annually over that time frame (although the dividend has grown by 9% annually over the past five years).

This merger has effectively created a duopoly in the American tobacco market. Every year, there is about $100 billion of tobacco sales in the U.S. About $50 billion comes from Altria, and $35 billion comes from the post-merger Reynolds. Together, they are 85% of the industry, and it diminishes the likelihood that the two companies will engage in price competition with each other.

It’s just this…crazy consolidation of power. I thought Coca-Cola was a big deal because 3.5% of the liquid consumed in the world falls under the banner of The Coca-Cola Empire. That is nothing compared to what Altria and Reynolds have now done in the United States. If you owned shares of each, for every ten men you saw walking down the street smoking, all but one or so of them would be transferring cash to your pocket.

I don’t understand the people who sell stocks because they become moderately overvalued. It seems to me that one of the major fruits of long-term business ownership is that, in additional to capital gains, you’d want to capture the big earnings per share and dividend gains that the company experiences. Well, when a company is hitting its stride, telling you about profit growth every quarter and bringing the dividend up along the way, the price of the stock is going to go up to match that performance.

Did you see what happened with Visa stock today? It reported 11% revenue gains, and the stock went up $7 per share in after hours trading. You’ll wake up tomorrow to see Visa at $77, or a pre-split adjusted $308. It’s crazy to think that just last summer it was selling at a pre-split adjusted $200. The valuation is admittedly extended, but you don’t sell a company when it is performing especially well unless the valuation becomes completely detached from the fundamentals (Visa is another 25% or so away from that mark).

Likewise, Reynolds American now has a 65% dividend payout ratio, and is expecting strong earnings growth in the years ahead. That $0.67 quarterly dividend could hit $1 within six years. It’s going to be returning a lot of cash to shareholders over the medium term.

That said, I would *not* recommend buying the stock now. Even with the new earnings expectations of $4.15, the current $79 share price reflects a P/E ratio of 19. Most of the profits originate in the United States, and the Pound Sterling to U.S. Dollar conversion has had a limited effect on distorting the real picture, so what you see here is what you get. Reynolds is a company that normally trades at 12-14x earnings.

It has done that for most of its history, and that valuation reflects common sense when you consider the regulatory, social, and tax headwinds associated with the industry. It has taken rock-bottom interest rates and an extended bull market to push Reynolds up this far, and this is not the right time to hop on the carousel if you’re a new investor. Existing investors should take the dividend and put it into Chevron or something.

That’s just the way most of the American industries are right now. When you’re at all-time highs in an extended bull market fueled by low interest rates, you’re not going to find many rock-bottom deals. That is why most of my enthusiasm is limited to the energy industry, and a few small-caps here and there that benefit from a lack of overall coverage.

It just strikes me how much sentiments shift, in the wrong way related to valuation. In 2000, when tobacco was heavily litigated and the P/E ratio of the stocks in the industry was 7-9x earnings, no one wanted to buy these companies even though companies like Reynolds have returned 23% annualized since 2000. It was a once in a lifetime thing–a $25,000 RAI investment in 2000 would be $630,000 today.

Meanwhile, people couldn’t get enough of Chevron last summer when the price was over $130, and now that it is in the low $90s, people can’t run away fast enough even though it pumps more than 1 million barrels of oil from the ground per day. The dividend is supported by earnings, and you collect 4.5%. What’s to get upset about?

In the medium term, however, the business fundamentals at Reynolds appear bright. Sales had been growing at Reynolds before the merger, and it now owns Newport, which is resistant to volume losses and generates lucrative profits. The earnings quality at Reynolds has certainly improved as a result of this transaction, and the 65% dividend payout ratio indicates meaningful room to run during the 2015-2020 stretch.