Cigarette Sales Are Declining, So How Sustainable Is Philip Morris' Dividend?

Tobacco companies are often considered some of the most defensive stocks you can find in the market thanks to their great dividend yields. Indeed, industry leaders Philip Morris International and Altria Group are well known and respected for their shareholder returns, which are second to none. However, with the number of smokers worldwide in terminal decline, how safe are these payouts?

Building trust
Tobacco companies did not get the reputation they have today by accident; they have built up their reputation for returns over decades without breaking any promises. For example, Altria and its tobacco sector peer Universal have both been paying and increasing their dividend payouts, without a single cut, for more than four decades.

Unfortunately, as of yet Philip Morris and its management team have not been around long enough to build up this kind of reputation. Nevertheless, Philip Morris' management appears to know what they are doing and in my opinion, the team has been extremely prudent in ensuring the long-term sustainability of the company's payout. In particular, after Philip Morris and Altria parted ways during 2008, in its first full year of independence Philip Morris' operations yielded $8.1 billion in cash, from which the company paid out a total of $5.1 billion in dividends to investors.

Now, Philip Morris could have paid out a lot more than this in theory, but it remained cautious and paid out only what it believed it could afford. Since then the company's payout has edged up, rising from an initial quarterly payout of $0.46 per share in 2008 to a quarterly payout of $0.94 per share at present.

However, while Philip Morris' payout has more than doubled, it has only grown in-line with funds generated from operations. Specifically, the company paid out 55% of cash from operations as dividends during 2013, 53% during 2012, 50% during 2011, and 54% during 2010. Over the same period the company's payout has risen from $0.58 to $0.94 -- impressive growth without putting an excessive strain on the company's cash flows.

Falling sales
Still, the major factor that threatens the dividend payouts of both Philip Morris and Altria is falling cigarette sales around the world, although it would appear that these tobacco behemoths aren't worried.

You see, big tobacco continues to increase prices to offset declining volumes. For example, back in December of last year Altria added $0.07 per pack to the price of Marlboro cigarettes. This follows a similar $0.06 increase in June.

According to data supplied by the Tobacco Atlas, a pack of Marlboro cigarettes within the United States costs $6.36 on average, which implies that the total price increase of $0.13 per pack for this year would be a 2% rise all-in-all. Note that this calculation includes taxes.

Now, we can factor this into Altria's results to see how it helps keep the company's profits rising.

Specifically, for the first nine months of this year, the volume of Marlboro cigarettes sold by Altria declined by 3.8%. However, with the company instigating a price increase of 2%, this effectively means that the revenue received from the volume of cigarettes sold declined by only 1.8%. These numbers, along with price increases across the rest of the company's tobacco portfolio and an increase in the volume of discount cigarettes sold, meant that Altria's revenue from cigarettes remained fairly constant throughout 2013.

What's more, lower costs and lower excise taxes helped Altria's adjusted operating income from smokeable products rise 16% year over year for the nine months ending in September.

Another opportunity
If Philip Morris is not your cup of tea and you're still looking for a trustworthy dividend-paying company, McDonald's could be a great pick.

During the five-year period between 2008 and January 2014, McDonald's increased its dividend payout to investors by 116%; actually this growth is faster than Philip Morris' dividend growth over the same period. In addition, during the same five-year period, McDonald's has repurchased 21.4% of its outstanding shares. Figures from last year show that McDonald's returned $5 billion to investors during the year through both buybacks and dividends -- this works out to around $5 per share.

Further, just like Philip Morris, McDonald's has plenty of capacity to increase its dividend payout during the next few years or even, if the company can continue to innovate, indefinitely. Indeed, during the past five years, McDonald's has generated around $21 billion in free cash flow from operations. From this free cash flow, McDonald's has paid out around $13 billion in dividends to investors, only 62% of free cash flow. I should also mention that over the same period the company's operating cash flow has expanded 22%.

So, as McDonald's cash flow continues to expand, the company's dividend payout should grow as well; although even if cash flows start to contract, the company has plenty of space for dividend growth.

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The article Cigarette Sales Are Declining, So How Sustainable Is Philip Morris' Dividend? originally appeared on Fool.com.

Rupert Hargreaves owns shares of Altria Group. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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