While it may come as a surprise, history has shown us many of the best long-term investments are not hypergrowth companies but much more boring dividend growth machines.
For example, in the last 50 years, Altria Group Inc. (MO, Financial) has been one of the best-performing stocks on a total return basis, rising an incredible 6,648-fold.
Back in 2008, Altria spun off its faster-growing international tobacco business, Philip Morris International Inc.Ă‚ (PM, Financial).
Since then, Philip Morris has increased its dividend for nine consecutive years, rewarding shareholders with 10.7% annualized dividend growth.
While this high-yield stock’s past performance has been remarkable, investing gains are not made by looking in the rearview mirror but instead are based on forward cash flow growth.
We will take a closer look at Philip Morris to see what kind of income growth and total returns shareholders can expect going forward and whether this dominant tobacco company is an appropriate stock for investors living off dividends in retirement.
Business description
Philip Morris is the world’s largest tobacco seller with 80,000 employees operating 48 production facilities in 32 countries.
It markets numerous cigarette brands to over 150 million customers in over 180 countries and has a 27.9% global market share (excluding China and the U.S.).
Philip Morris owns the international rights to all of Altria’s most famous brands including Marlboro, Merit, Parliament, Virginia Slims, L&M, Philip Morris, Bond Street, Chesterfield, Lark, Muratti, Next and Red & White.
In addition, the company has acquired numerous foreign cigarette brands, including
- Dji Sam Soe, Sampoerna and U Mild (Indonesia).
- Champion, Fortune and Hope (Philippines).
- Apollo-Soyuz and Optima (Russia).
- Morven Gold (Pakistan).
- Boston (Columbia).
- Belmont, Canadian Classics and Number 7 (Canada).
- Best (Serbia).
- f6 (Germany).
- Delicados (Mexico).
- Assos (Greece).
- Petra (Czech Republic and Slovakia).
As you can see, Philip Morris' sales are pretty evenly diversified with the vast majority of sales coming from Europe and Asia.
The European Union remains the company’s most profitable region by far, generating more than 35% of the company’s total operating income in 2016.
| Region | 2016 Sales | % of Sales | Operating Income | % of Income |
| European Union | $8.162 billion | 30.6% | $3.994 billion | 35.8% |
| Eastern Europe / Middle East / Africa | $7.000 billion | 26.2% | $3.016 billion | 27.1% |
| Asia | $8.681 billion | 32.5% | $3.196 billion | 28.7% |
| Latin America / Canada | $2.842 billion | 10.7% | $938 million | 8.4% |
| Total | $26.685 billion | 100.0% | $11.144 billion | 100% |
Source: Philip Morris International Earnings Release
Business analysis
Philip Morris is an absolute giant in the global tobacco world.
The company is the market leader in seven of the 10 largest Organization for Economic Cooperation and Development (OECD) countries by industry volume and is the second-largest player in another two.
Outside of OECD countries, Philip Morris holds the No. 1 market share spot in three of the 10 biggest countries by industry volume and is the No. 2 player in another four.
The company’s dominance is driven by the strength of its brand portfolio. Philip Morris has six of the world’s top 15 cigarette brands including the world’s No. 1 brand – Marlboro.
As a result, the company enjoys excellent pricing power. Since 2008, Philip Morris’ annual average pricing gain has been 6% excluding excise taxes.
Despite its strengths, the company has run into some major growth headwinds in recent years with sales and earnings grinding to a halt or even turning negative.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
Part of this is due to lower cigarette volumes since smoking is an industry in secular decline.
In fact, Philip Morris reported that its cigarette shipment volume was down 4.1% in 2016 (although roughly 40% of the decline was due to Pakistan and the Philippines, where volume erosion was concentrated in low unit margin brands).
Most of its brands saw flat or negative declines in volumes as did all regions (although volume in the EU was down just 0.5%). However, it is important to note that Marlboro gained market share in the EU (up 0.2%), Asia (up 0.3%) and Latin America and Canada (up 0.6%).
Source: Philip Morris International Earnings Release
One of the reasons for the volume declines is higher government taxes in some of Philip Morris’ largest regions, such as the EU, Russia and the Philippines (three of the company’s top four markets).
The EU implemented anti-smoking legislation in mid-2014, aiming to reduce tobacco consumption by 2% over the next five years, the equivalent of 2.4 million smokers. The EU has one of the highest excise tax rates on tobacco in the entire world, and roughly 70% of Philip Morris’ revenue from the region goes to the government.
In 2013, the Philippines raised excise taxes to boost the average price per cigarette pack by a whopping 48%. Annual excise taxes are expected to continue in the region through 2017 and beyond, putting more profits in the government’s coffers at the expense of Philip Morris’ bottom line.
Russia initiated a new law in 2013 that banned smoking in many public places and restricted advertising. Excise taxes in Russia have more than tripled the cost of a pack of cigarettes since 2006.
As you can see below, excise taxes have increased from 59.5% of Philip Morris’ revenue in 2012 to 64.4% in 2016, eroding its gross margins by 4%.
Source: Simply Safe Dividends
Interestingly enough, Altria’s excise taxes as a percentage of sales (24.9% in 2016) are less than half of Philip Morris’ and have decreased by four percentage points since 2012, boosting gross margins.
Source: Simply Safe Dividends
A somewhat more favorable outlook in the U.S., continued industry consolidation and growth in reduced-risk products such as iQOS (more on that later) have led many investors to speculate that Altria and Philip Morris could merge.
Besides government policies, a major factor to the company’s slowing growth is the rising dollar, which means sales in foreign currencies are reduced when they are converted to dollars for reporting purposes.
In 2016, Philip Morris’ negative currency effects on net revenue and earnings per share came in at -4.8% and -10.4%.
Latin America especially was the scene of some brutal currency losses due to the ongoing recessions in Brazil, Venezuela and other commodity-dependent nations.
However, while operating margins declined from 17.9% in 2012 to 14.4% last year, the company has managed to use aggressive cost cutting to maintain impressive and far more stable returns on investor capital.
Better yet, in recent quarters, the dollar has stopped its relentless march upward, allowing margins, sales and earnings to recover.
A lot of this improvement has to do with Philip Morris’ wide moat, driven by the company’s excellent brands and pricing power.
This helps keep revenues stable and hopefully growing despite the ongoing cigarette volume pressure caused by rising global anti-smoking sentiments.
In fact, the company’s pricing power is so strong that, if you exclude currency effects, its latest full-year results show positive revenue growth.
Meanwhile, management’s guidance for 2017 calls for adjusted EPS (excluding currency) growth of 9% to 12% – about in line with 2016’s adjusted EPS growth rate of 11.8%. Not bad at all for such a mature business.
While Philip Morris’ strong brand equity and pricing power make for generally stable sales and margins (and  for some very impressive free cash flow generation), the company’s overall profitability is actually a bit below industry average.
That is a result of only Marlboro being a truly global brand, which limits the economies of scale it can deliver on its other brands, especially those limited to just one or two nations.
For comparison’s sake, Altria’s cigarette market share is 51.4%, nearly double Philip Morris’ thanks to its focus on just the U.S.
Still, no one can really complain about margins in excess of 20%.
| Company | Operating Margin | Net Margin | FCF Margin | Return on Assets | Return on Equity | Return on Invested Capital |
| Philip Morris | 38.7% | 24.8% | 25.8% | 19.2% | NA | 51% |
| Industry Average | 46.6% | 27.4% | NA | 13.9% | 155.6% | NA |
Source: Morningstar
Management is also working hard to insulate itself from the worst of the long-term decline in global smoking habits with its strong push to reduced-risk products, or RRPs.
Specifically, the company has invested $3 billion since 2008 in developing its iQOS heat stick (which does not burn tobacco) and its MESH vaporizer technology (which creates a nicotine-rich vapor with none of the carcinogenic chemicals found in tobacco).
While the actual percentage of sales from RRPs is still very low (4.9% of fourth-quarter 2016 net revenues excluding excise taxes), the company has seen strong growth in iQOS, first in Japan (where it was initially tested and 20% of its customers have already switched) and also in other nations where it has recently launched the product.
As you can see below, HeatSticks saw their market share rise from 0.8% at the start of 2016 to 4.9% by the end of the year in Japan.
IQOS volume trends are rising around the world as well, and Philip Morris is investing in additional manufacturing capacity to meet demand. This is key to the company’s very long-term future:
A big plus for Philip Morris is that if iQOS can indeed become the dominant brand of future smoking alternatives, then its world-class access to tobacco will give it large economies of scale.
That could allow it to maintain its strong profitability and returns on shareholder capital for many years to come.
It is worth noting that the company submitted a product application for its iQOS product to the Food and Drug Administration (FDA) at the end of 2016, which would open up a large market opportunity for Philip Morris (further fueling speculation of an Altria-Philip Morris reunion).
Only time will tell whether Philip Morris’ customers decide that “heat-not-burn” alternatives to traditional cigarettes are truly fulfilling substitutes, and more importantly whether they wish to continue using them or just use them as tobacco cessation methods.
The early traction is encouraging as Philip Morris looks to gradually shift its business from being a manufacturer of combustible tobacco products to an RRP-focused company.
Key risks
There are three important risks to consider before investing in any tobacco stock –Â but Philip Morris in particular.
First, understand that the company has no exposure to the world’s largest smoking population, China (where 30% of global smokers reside).
While other developing economies like India are potential growth markets, the risk of governments becoming increasingly anti-tobacco due to rising global health costs is ever present.
Source: World Health Organization
In fact, in recent years, governments around the world have started to increasingly crack down on tobacco including bans on marketing, steadily rising taxes that threaten to eventually price many people out of the market and increasingly gruesome warning labels on packaging.
Source: VOX
Such warning labels, as well as an increasing regulatory pressure for “plain packaging” that limits branding, is a threat to not just the company’s brand and thus wide moat, but research out of Australia indicates that it can have a noticeable decrease on smoking rates.
Finally, while RRPs like iQOS represent a necessary adaptation to the future realities of declining smoking rates worldwide, keep in mind that regulators around the globe have remained largely hostile to these smoking alternatives.
In other words, while reduced-risk products may help to slow the decline in product volume, they probably won’t be able to halt it entirely.
Continued price increases and financial engineering (i.e., reducing share count over time) will become increasingly important components of tobacco companies’ long-term investment thesis.
That’s because in an industry facing secular decline, however gradual the decline might be, a falling share count is necessary to help maintain EPS and FCF per share growth, the cornerstone of a safe and growing dividend.
However, Philip Morris International in particular has an issue of rising debt levels as the company has taken on a lot of debt in recent years to fund its aggressive buybacks (2.1% CAGR over the last five years).
Source: Simply Safe Dividends
In a rising interest rate environment, the company could have to slow the pace of buybacks, which will make EPS, FCF per share and dividend growth a bit harder to come by in the coming years.
If rising U.S. interest rates result in a further strengthening of the dollar, growth headwinds could intensify as well.
If the dollar ends up rallying, management’s 2017 earnings guidance may prove out of reach.
While currency fluctuations are unlikely to impact Philip Morris’ long-term earnings power, they could remain a headwind for the stock over the short to medium term.
Dividend Safety analysis: Philip Morris International
We analyze 25-plus years of dividend data and 10-plus years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been and how to use them for your portfolio here.
Philip Morris International has a Dividend Safety Score of 87, indicating that its dividend is safe and dependable.
This is because the tobacco industry is generally seen as nondiscretionary (i.e., “recession proof”) by its consumers, due to the addictive nature of the product.
As a result, Philip Morris International managed to grow its dividend even during the worst financial disaster since the Great Depression. The company’s sales fell by just 2% in 2009, and its free cash flow per share managed to grow.
Source: Simply Safe Dividends
In addition, until recently Philip Morris maintained a reasonably low payout ratio, leaving plenty of excess earnings and cash flow to provide a buffer to insulate the dividend against any unexpected declines in business.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
However, be aware that due to the recent weakness in its results (mostly due to the stronger dollar), Philip Morris’ trailing 12-month EPS payout ratio is 92%.
If currency fluctuations are excluded, the company’s EPS payout ratio in 2016 was closer to 83% – still high but not as alarming for a stable business such as Philip Morris.
The dividend remains secure, but it’s increasingly important that Philip Morris deliver on its guidance for 2017 and beyond despite some of the growth challenges previously discussed.
Of course, that doesn’t necessarily mean the dividend will become unsafe. After all, despite taking on a lot of debt to fund buybacks over the last few years, Philip Morris International still has a pretty strong balance sheet.
For example, with a current ratio above one and a high interest coverage ratio, the company has no trouble servicing either its debts or short-term liabilities.
Source: Simply Safe Dividends
Now admittedly Philip Morris has a more leveraged balance sheet than the average tobacco company. However, its strong pricing power and high FCF margin mean that the company retains a strong credit rating and access to cheap debt.
| Company | Debt / EBITDA | EBITDA / Interest | Debt / Capital | Current Ratio | S&P Credit Rating |
| Philip Morris | 2.74 | 11.74 | 136% | 1.16 | A |
| Industry Average | 1.96 | NA | 81% | 1.16 | NA |
Source: Morningstar
In a worst-case scenario, in which earnings and FCF were to decline and its dividend payout ratio rose above 100%, the company could very likely still afford to borrow for a year or two to keep the dividend alive and well.
Dividend Growth analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is good, and 25 or lower is considered weak.
Philip Morris International has a Dividend Growth Score of 33, indicating that investors can expect some pretty weak payout growth in the next few years.
That’s not surprising given the decelerating pace of dividend growth in the last few years. As a rising dollar and slowing sales growth has taken a toll on the payout ratios, which are now at the upper limits of sustainability, Philip Morris will need to greatly slow the pace of future dividend growth in order to increase its payout security.
As seen below, the company’s dividend growth has decelerated from 7.9% per year over the last five years to just a 2% rise in 2016.
While growth has been slow, it has been reliable. Philip Morris will join the Dividend Achievers list in 2018 after its 10th consecutive year of raising dividends.
Source: Simply Safe Dividends
How fast could Philip Morris’ future dividend growth be? Analysts expect long-term sales growth of 4% to 5% (beyond 2017), driven entirely from rising prices.
In addition, cost cutting is expected to boost long-term operating ratios by 3% and allow for long-term EPS growth of 6%.
Considering the company’s high payout ratio and some of the growth headwinds potentially facing the business, Philip Morris investors probably shouldn’t expect dividend growth of more than 3% to 5% or so annually over the next decade.
Valuation
Over the past year, Philip Morris stock has returned 12%. While that is underperforming the Standard & Poor's 500, which is up 20%, shares of this international tobacco blue chip don’t look cheap.
Based on management’s 2017 adjusted EPS guidance, Philip Morris stock trades at a forward price-earnings (P/E) multiple of 19.9.
The stock’s 4.2% dividend yield is in line with its long-term median dividend yield (4.2%), according to data from GuruFocus.
While Philip Morris has excellent profitability, stable cash flow and a safe dividend payment today, its current valuation multiple seems a little steep based on some of the growth headwinds facing the business and its high debt load.
If Philip Morris is able to deliver long-term EPS growth of 5% to 6% per year, the stock appears to offer annual total return potential of about 9% to 10% per year (4.2% dividend yield plus 5% to 6% earnings growth).
A 10%-plus pullback in the stock would make for a more interesting adding opportunity to consider.
Closing thoughts on Philip Morris International
Assuming you are willing to overlook the secular decline of the tobacco industry as a whole, Philip Morris International has the potential to be a solid high-yield dividend growth investment for long-term investors.
I plan to continue holding the stock in our Conservative Retirees dividend portfolio, but income investors considering opening a position in Philip Morris International might be better off waiting for a more appealing price.
Disclosure:Ă‚ The author is long Altria and Philip Morris.
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