Philip Morris International Inc. (PM, Financial) is considered to be one of the market’s most defensive dividend stocks. The world’s largest (soon to be overtaken by British American Tobacco (BTI, Financial)) cigarette producer is a highly defensive business. The addictive nature of its products ensures the money continues to roll in while the high margin on cigarettes means the company is one of the most profitable in the world, which is great news for shareholders.
But the world is changing, and Philip Morris is at risk of being left behind as consumers are increasingly shunning tobacco products.
Price and volume
Over the past 10 years, the company has been able to offset declining cigarette volumes by increasing prices. Higher prices have helped increase profitability and have given the company plenty of headroom to continue increasing its per-share dividend payout as well as spending billions of dollars on share buybacks.
It seems as if this strategy has now reached, or is reaching, its limits. In the first two quarters of this year, Philip Morris’ shipment volume declined 9.4%, the largest drop on record for the company. Including heated tobacco units, the volume decline was slightly better at 7.1%, but still significant. More telling is the fact that during the second quarter the total value of cigarette sales decreased 3.4%, showing the company’s strategy of hiking prices to offset the volume declines is no longer working.
Still, despite the bad news, the company reported an increase in overall revenue of 4% thanks to an increased contribution from so-called “reduced risk products.” During the quarter, sales from this small but growing division rose to $615 million from $123 million. Management is pinning the company’s hopes for growth on these products, and so far it seems as if this strategy is paying off. During the second quarter, almost 9% of Philip Morris’ worldwide revenues came from these reduced risk products, up from 1.8% a year earlier. Management believes the company will eventually stop selling cigarettes and shift entirely to these reduced risk, heat not burn products, which is enough to convince some Wall Street analysts that Philip Morris has a brighter future ahead of it.
A growth company?
The big question is whether the shift toward heat not burn  is going to be a short-term trend or a long-term solution to the company’s problems.
Even though reduced risk products are taking off, they are still toxic to your health; hence the reduced risk, not risk-free label. Considering the wider trends affecting the global cigarette market, it is tough to say with any certainty these reduced risk products will be Philip Morris’ savior. Yes, they may slow the company’s decline, but every developed economy is trying to clamp down on smoking, no matter what form it takes. Against this uncertain backdrop, shares of Philip Morris should attract a modest valuation. Unfortunately, the market has placed a growth multiple on the company. The shares are trading at an enterprise value to earnings before interest, taxes, depreciation and amortization ratio of 18.8, significantly above the market median of 14.3.
The shares also support a dividend yield of 3.64%, which might make them attractive for income investors even though the company’s balance sheet is creaking under an enormous debt load.
At the end of 2016, the company had a book value per share of $-7.7. Even though Philip Morris’ cash flow is substantial and the company has plenty of cash available to fund its interest obligations, negative shareholder equity implies it is dependent on the kindness of strangers to remain in business – never a good trait for a dividend stock.
Conclusion
Add all of the above together and it is clear there are better stocks out there than Philip Morris. While investors have flocked to the company due to its dividend yield and defensive nature, the premium valuation and mixed fundamental backdrop make it difficult to assess its long-term potential; an enormous debt mountain only makes this problem more complicated.
Disclosure: The author owns no stock mentioned.
