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Philip Morris Is Addicted to Dividend Increases

Published September 10th, 2014

Philip Morris (PM) announced it is raising its dividend this morning by 6.4% to $4.00 per share.  The ex-dividend date for investors looking to take advantage of the company’s 4.7% yield is September 23, 2014.  The dividend hike is not surprising as the company has raised its dividend payment each year since separating from Altria (MO).

Philip Morris stock should appeal to shareholders seeking income.  There are few stocks in this market that offer yields as high as Philip Morris.  The S&P500 has a yield of under 2%.  Philip Morris pays over twice as much to its shareholders as the market as a whole.

Capital Allocation Master

Philip Morris is simply one of the best run businesses I have analyzed.  They understand their value is in their strong cash flows.  The company does not hoard cash for “future investments” like many other businesses.  Instead, Philip Morris uses its cash flows to reward shareholders with share repurchases and substantial dividends.

Philip Morris has maintained a payout ratio of around 70% over the last 5 years.  The company’s high payout ratio is appropriate for a mature company in a mature industry.  Philip Morris has paid out over 100% of its operating cash flows to shareholders each year since 2009 if you include dividends and share repurchases.  In fact, Philip Morris has averaged returning about 113% of operating cash flows to shareholders since 2009.  The company has managed to do this by leveraging itself with long-term debt.

Some shareholders will balk at the company taking on debt to sustain its strong share repurchases and dividend payments.  I believe the strategy is very sound in today’s low interest rate environment.  The policy of central banks around the world has been to keep interest rates artificially low.  The company is not borrowing because it has to; it is borrowing because it is the most intelligent financial move to make for a business with predictable cash flows.

Philip Morris can reduce or eliminate its share repurchases at any time and have plenty of space to grow its dividend.  Philip Morris average interest rate on its long-term debt is under 4%.  The company has a dividend yield of 4.7%.  When the company can borrow money and buy back shares for less than 4% a year, it is actually saving money, if you assume the company has no plans to cut its dividend payments (which it almost certainly does not).  Philip Morris owes about 3.7% interest for its long-term debt, and it can use this debt to buy back its shares which it pays 4.7% a year on to shareholders, netting the company a difference of about 1% for every share repurchased.

Not only is the move beneficial for Philip Morris, it is also beneficial for shareholders.  The less shares outstanding of Philip Morris stock, the higher percentage of the company each shareholder owns.  The company has reduced its share count by over 20% since spinning off from Altria, and will likely continue to repurchase shares.

But Won’t High Debt Sink The Company?

Debt in itself is not dangerous.  Debt becomes dangerous when you have limited room for error.  Fortunately, Philip Morris has an interest coverage ratio of… Not 3, 5, 7 or even 10, but 15.7.  If the company’s earnings fall by a factor of 15, I would argue Philip Morris has much more dire problems than having a large amount of debt.  Philip Morris is still conservatively financed on a debt to cash flow measure despite having a large amount of debt compared to its assets.  The distinction is very important to make as the value of Philip Morris is not in its assets, but in its strong cash flows.

Future Dividend Growth

Philip Morris has an earnings per share growth guidance of 6% to 8% over 2014.  I believe the company can keep this rate of earnings per share growth for the long-term.  Philip Morris operates globally, and has the opportunity to gain market share in several developing markets around the world.  Secondly, the company has proven that it can raise prices faster than governments increase cigarette taxes.  This gives Philip Morris the ability to expand margins and pass price increases off as ‘forced’ by governments.  The addictive nature of cigarettes causes consumers to purchase them even at higher price points.  Finally, the company can add a few percentage points of growth annually by repurchasing shares.  Over the last 5 years, Philip Morris has managed to grow revenue per share at about 8.6% a year, above its current guidance.

Shareholder Return & Final Thoughts

Based on the information above, I believe shareholders of Philip Morris will see dividend growth of at least 6% a year, as we saw with this year’s dividend increase.  Growth (6%+) and dividends (4.7%) together will very likely give shareholders of Philip Morris a CAGR of over 10%.

The 8 Rules of Dividend Investing use quantitative rules that have historically improved returns to identify high quality businesses with a long history of dividend payments suitable for long-term investors.

Philip Morris ranks as a strong buy and Top 10 stock using the 5 buy rules from the 8 Rules of Dividend Investing.  The company is a high quality dividend blue chip with a long history of success.

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