Philip Morris: Innovating to Protect and Grow Its 4.7% Dividend - Sure Dividend Sure Dividend

Sure Dividend

High Quality Dividend Stocks, Long-Term Plan
Get Top 10 Stocks in Sure Dividend Newsletter NowGet The 5%+ Yield Sure Retirement Newsletter Now

Philip Morris: Innovating to Protect and Grow Its 4.7% Dividend


Published December 1st, 2016 by Bob Ciura

Philip Morris International (PM) built a cigarette empire—but it is increasingly looking towards a post-cigarette future.

The tobacco industry has not typically been associated with innovation. That is a term usually reserved for technology companies. After all, a cigarette today probably looks a lot like it did four or five decades ago.

But this is a new era for Big Tobacco. Smoking rates continue to decline, and regulatory scrutiny is heating up. PM has recognized that the cigarette business may continue to deteriorate.

That is why PM is taking the lead on innovating new products, to meet the changing demand. This is great news for PM shareholders. Adapting to the evolving marketplace will be critical for the company, to protect and raise its dividend going forward.

Well-known investor Kevin O’Leary has taken notice.  Philip Morris is one of the largest holdings in Mr. Wonderful’s quality dividend ETF (OUSA).

This article examines the investment prospects of Philip Morris in detail.

Business Overview

PM is a global tobacco giant. It manufactures and distributes the Marlboro brand outside the U.S. It has a market cap of $137 billion.

This is a difficult time for PM. Its earnings are being negatively impacted by a number of factors. These include the strong U.S. dollar, slowing economic growth in the emerging markets, and falling smoking rates.

As an international company, the U.S. dollar has increased relative to other global currencies. This has caused exports to become less competitive. Last year, PM’s revenue fell by $4.7 billion just from currency.

Overall, PM suffered a 10% decline in revenue and a 12% decline in earnings-per-share last year.

If that weren’t bad enough, smoking rates are falling in developed markets where PMI operates. Cigarette volumes declined 3.9% over the first three quarters of 2016. This is an added headwind putting even more pressure on PMI.

It appears likely that smoking rates are only set to decline further from here. One reason is the adoption of plain packaging laws in some key markets like Britain.

As a result, PM has set a new course. Management stated in a recent interview with Reuters that it sees a post-cigarette future for itself.

To get there, it recently unveiled a new product line, which PM refers to as its reduced-risk portfolio.

pm-reduced-risk-product

Source: Morgan Stanley Global Consumer & Retail Conference, page 5

The iQOS product line is the result of a long and arduous endeavor for PM. It invested 10 years and $3 billion of R&D into the product.

This is a big step for PM. Not only are volumes increasing, it is taking share as well. The iQOS lineup is doing particularly well in Japan, a major market for the company.

pm-iqos-japan

Source: Morgan Stanley Global Consumer & Retail Conference, page 6

Competitive Advantages

One of the biggest reasons to invest in tobacco companies is because of the extremely favorable economics. First, the tobacco industry benefits tremendously from economies of scale.

PM and other Big Tobacco companies have very streamlined manufacturing and distribution processes. This cuts down on costs significantly. The tobacco industry is not capital-intensive, which results in very high free cash flow.  And the company is extremely adept at allocating capital.

Last year, even with PMI’s various challenges, the company still generated $6.9 billion of free cash flow, up 5% from the previous year.

pm-free-cash-flow

Source: 2016 Annual Meeting of Stockholders, page 27

Plus, selling an addictive product provides PM with tremendous pricing power.

It relies considerably on price increases to produce revenue growth. Last quarter, revenue was boosted by $440 million from price hikes.

Such a strong financial position provides PM with the financial flexibility to escalate product R&D when it feels necessary. PM has allocated billions to the development of iQOS, without having to raise external capital, while continuing to raise the dividend.

PM’s willingness to accept the difficult future facing traditional cigarettes should pay off in a big way. By investing in new product technology ahead of its competitors, it has gotten to market first. This will give it a crucial first-mover advantage. Now, other global Big Tobacco majors will have to catch up to PM’s lead.

The appeal of the iQOS for consumers is that it electronically heats tobacco to produce a vapor, rather than burning it. According to PM, this results in less harmful residue like ash. PM states tobacco vapor has less than 10% of the amount of harmful chemicals found in cigarette smoke.

PMI initially rolled out the product in 13 test markets. The results have been very promising thus far. Heated stick shipment volume soared 75% last quarter.

pm-iqos-volume

Source: Morgan Stanley Global Consumer & Retail Conference, page 7

Consumer adoption of the product is increasing across several markets. Because of the strong performance in the early going, PM plans to further expand iQOS to 20 markets by the end of 2016. It could be in as many as 35 markets by the end of 2017.

Dividend Analysis

PM is committed to providing shareholders with a competitive, and growing, dividend. Since the 2008 spin-off, PMI has increased its regular quarterly dividend by 126% from the initial annualized payout of $1.84 per share.

It has achieved eight consecutive annual dividend increases. With two more, it will become a Dividend Achiever. You can see the entire list of all 273 Dividend Achievers here.

In fairness, PM’s dividend history really stretches back more than 40 years (with increases every year) if one includes its history with Altria (MO).

But, due to the challenged business climate, PMI’s rate of dividend growth has slowed. The 2016 dividend raise was just 2%.

That is because, as its earnings-per-share decline, its payout ratio is rising. PMI’s trailing 12-month payout ratio is nearly 100%. That makes it very difficult to raise the dividend.

Fortunately, PMI sees earnings-per-share, adjusted for currency, to rise 10.5%-11.5% this year. This organic growth is due largely to penetration of its new product line across the world.

PMI’s product innovations are a very positive step towards rejuvenating its earnings growth, and in turn, its dividend growth.

Final Thoughts

PMI has a tantalizingly-high dividend yield of 4.7%. But a high yield can sometimes be a red flag, if the dividend is not sustainable. Investors need to make sure a high dividend payout is supported with underlying cash flow.

While PMI’s payout ratio has gotten tight, there is a good chance the company can return to double-digit growth, excluding foreign exchange. The iQOS and reduced-risk product portfolio will be major contributors to future growth.


See Our Best ideas
Get Top 10 Stocks in Sure Dividend Newsletter NowGet The 5%+ Yield Sure Retirement Newsletter Now