On the face of it, tobacco companies make some of the best income stocks out there with dependable income streams from addicted customers, high cash flow due to premium pricing power, and low capex requirements leaving plenty left to return to shareholders. But should income-hungry investors still flock to British American Tobacco (LSE: BATS) for all their dividend needs?
Well, after rising over 50% in value over the past two years the company’s stock only yields 3.2%, which is below the FTSE 100’s average 3.84% yield as of June 30. However, given that BATS’ payout is covered 1.46 times by earnings and that the dividend safety of some of the largest yielders out there such as Pearson, Shell and BP is suspect, conservative investors may find it worth taking the lower but safer yield.
And its healthy dividend is about as safe as they come these days as it’s supported by sales, profit and earnings growth. In the half year to June, the firm increased constant currency adjusted sales by 2.5% year-on-year (y/y), and adjusted operating profits by 3.2% y/y as operating margins rose by 30 basis points to 37.1%. Revenue growth is being driven by increased market share in key markets as well as management increasing prices to compensate for falling volumes.
Statutory results in actual exchange rates were even better thanks to the weak pound, which allowed the interim dividend to rise 10% to 56.5p. And looking ahead, there should be further income growth as BATS completed its £41.7bn acquisition of Reynolds America post-period end. This will increase the company’s market share in the most profitable tobacco market outside China and offer even more pricing power with suppliers and customers.
And while BATS’ post-deal net debt-to-EBITDA ratio will rise to four times, this isn’t too much of a worry given the company’s considerable cash flow and dependable income. At the end of the day, it may not be the single best income stock out there, but it pays out a safe and healthy dividend, offers decent growth prospects and is attractively valued at 19 times forward earnings.
A hidden income star
But if you’re after a bigger yield than BATS can offer, one option may be life insurance and pension plan manager Chesnara (LSE: CSN). The company pays out a very nice 5% dividend yield at today’s stock price and has raised dividends every year since going public in 2004. Last year the company’s payout was covered 1.41 times by earnings and with a year-end solvency ratio of 158% the company is in very good financial shape.
Looking forward, there is still considerable room for the company’s dividend payments to continue rising as it acquires its way into new markets, builds scale and improves cash flow from subsidiary companies. And there are plenty of potential acquisition targets as Chesnara pursues both small operators open to new business as well as large closed pension and life insurance books that it then outsources management of until the policies expire.
This business model isn’t without its risks but so far the company’s management team has proved adept at navigating rocky economic environments. With a stellar track record of raising dividend payments and a decent valuation of 11 times forward earnings, Chesnara is worth taking a closer look at for income-hungry investors.
But if it’s a safer dividend option you’re after, I recommend reading the Motley Fool’s free report, Five Shares To Retire On. Each of these five stocks has handily outperformed the FTSE 100 over the past decade thanks to bumper dividend payouts, wide moats to entry and defensive sales growth.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell B. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.