(Published Dec. 1 by Bob Ciura)
Philip Morris International (PM, Financial) built a cigarette empire, but it is increasingly looking toward 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. Philip Morris has recognized that the cigarette business may continue to deteriorate.
That is why Philip Morris is taking the lead on innovating new products, to meet the changing demand. This is great news for Philip Morris shareholders. Adapting to the evolving marketplace will be critical for the company, to protect and raise its dividend going forward.
Business overview
Philip Morris 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 Philip Morris. 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, Philip Morris' revenue fell by $4.7 billion just from currency.
Overall, Philip Morris 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 Philip Morris operates. Cigarette volumes declined 3.9% over the first three quarters. This is an added headwind putting even more pressure on Philip Morris.
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, Philip Morris 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 Philip Morris refers to as its reduced-risk portfolio.
Source: Morgan Stanley Global Consumer & Retail Conference, page 5
The iQOS product line is the result of a long and arduous endeavor for Philip Morris. It invested 10 years and $3 billion of R&D into the product.
This is a big step for Philip Morris. 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.
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.
Primarily, the tobacco industry benefits tremendously from economies of scale.
Philip Morris 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 high free cash flow, and the company is extremely adept at allocating capital.
Last year, even with Philip Morris' various challenges, the company still generated $6.9 billion of free cash flow, up 5% from the previous year.
Source: 2016 Annual Meeting of Stockholders, page 27
Plus, selling an addictive product provides Philip Morris 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 Philip Morris with the financial flexibility to escalate product R&D when it feels necessary. Philip Morris has allocated billions to the development of iQOS without having to raise external capital while continuing to raise the dividend.
Philip Morris' 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. Other global Big Tobacco majors will have to catch up to Philip Morris' lead.
The appeal of the iQOS for consumers is that it electronically heats tobacco to produce a vapor rather than burning it. According to Philip Morris, this results in less harmful residue like ash. Philip Morris states tobacco vapor has less than 10% of the amount of harmful chemicals found in cigarette smoke.
Philip Morris initially rolled out the product in 13 test markets. The results have been promising thus far. Heated stick shipment volume soared 75% last quarter.
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, Philip Morris plans to further expand iQOS to 20 markets by the end of this year. It could be in as many as 35 markets by the end of 2017.
Dividend analysis
Philip Morris is committed to providing shareholders with a competitive and growing dividend. Since the 2008 spinoff, Philip Morris 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, Philip Morris' dividend history really stretches back more than 40 years (with increases every year) if one includes its history with Altria (MO, Financial).
But due to the challenged business climate, Philip Morris' 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. Philip Morris' trailing 12-month payout ratio is nearly 100%. That makes it very difficult to raise the dividend.
Fortunately, Philip Morris expects earnings per share, adjusted for currency, to rise 10.5% to 11.5% this year. This organic growth is due largely to penetration of its new product line across the world.
Philip Morris' product innovations are a very positive step toward rejuvenating its earnings growth and in turn its dividend growth.
Final thoughts
Philip Morris 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 Philip Morris' 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.
Disclosure: I am long Philip Morris.
Start a free seven-day trial of Premium Membership to GuruFocus.
