Dividend growth investors are often drawn to securities with generous yields. This seems appropriate because the higher the yield, the more income produced. Sometimes, though, high yields can be a warning sign of the underlying business struggling. A high yield can also signal an upcoming dividend cut.
Other times, a business that is performing well can offer its shareholders a high yield that is unlikely to be cut. One of the best high-dividend stocks is Philip Morris International Inc. (PM, Financial).
Company background
Philip Morris International, one of the world's leading tobacco companies, was created when its parent company, Altria (MO, Financial), spun off its international operations in 2008. Philip Morris sells, among others, the Marlboro brand, which is one of the most popular brand of cigarettes in the world. In fact, Philip Morris has six of the top 15 international cigarette brands. The company also sells IQOS, its heat-not-burn product line that is intended to offer consumers reduced-risk products. Philip Morris has a market capitalization of $131 billion, with annual sales of nearly $30 billion.
Recent financial results
Philip Morris reported first-quarter results on April 18. The company’s adjusted earnings were $1.09 per share, which were 8 cents above estimates and a 9% improvement from the prior-year quarter. Revenue declined 2.1% to $6.8 billion, which was $13 million below estimates. Revenues would have been 3.2% higher if not for unfavorable currency translation.
While the headline numbers were mixed, the company reported a 1.1% increase in unit volumes shipped. Cigarette volumes were flat, which was an improvement from a 3.1% decline in the fourth quarter of 2018.
Heated tobacco unit volumes grew more than 20% in the first quarter. Reduced-risk products are the company's main growth catalyst moving forward. Smoking rates have been on the decline for years, so Philip Morris will likely need its IQOS products to continue to post solid growth rates going forward.
IQOS had 10.4 million users worldwide at the end of the first quarter. There were just 2.9 million users at the end of the first quarter in 2017. Philip Morris has been able to more than triple the IQOS users in the eight quarters since. The company expects its reduced-risk portfolio will see sales increase from $4 billion in 2018 to as high as $9 billion in 2021.
Philip Morris accounted for 28.4% of the tobacco market in the first quarter, a 1% increase from the previous year. The company expects to see shipment declines of 1.5% to 2% in 2019 versus a 2.5% to 3% decline in the tobacco industry. A lower decline rate against its industry as a whole is a sign of how strong the company's brands are in the marketplace.
Philip Morris expects revenue to grow at least 5% on a currency neutral basis in 2019. The company’s guidance for adjusted earnings per share is $5.09 for the year, slightly below consensus estimates of $5.17. We expect earnings to grow 5% annually through 2024 due to a combination of growth in the reduced-risk segment and a lower-than-average decline rates in the company’s cigarette products.
Dividend history
Philip Morris has paid a dividend every year since the spinoff from Altria was completed. The company compounded its dividend growth at a rate of 15% from 2009 to 2018. The dividend was increased 6.5% for the July 11, 2018 payment. Shares currently yield 5.3%, well above the average yield of 1.9% of the S&P 500.
The stock’s annualized dividend of $4.56 represents almost 90% of expected adjusted earnings per share for this year. While this payout ratio is elevated, the stock’s average payout ratio over the past five and 10 years is 88.4% and 76.3%. The current payout ratio isn’t too far above these longer-term averages.
Some investors prefer to measure dividend safety by free cash flow instead of earnings per share. In the first quarter, Philip Morris generated $1.24 billion in cash flow from operations and spent $324 million on capital expenditures for free cash flow of approximately $920 million. The company paid out $1.78 billion in dividends for a free cash flow dividend payout ratio of 193%. The first quarter tends to see the lowest amount of free cash flow during the year, so this type of ratio has been common in previous first quarters as well.
Expanding the time horizon, the situation looks much better. Philip Morris generated $9.5 billion in cash flow from operating activities in fiscal 2018 and spent $1.4 billion on capital expenditures for free cash flow of $8.1 billion. The company distributed approximately $6.9 billion of common share dividends during the same period for a free cash flow dividend payout ratio of 85%.
For 2019, Philip Morris expects to generate approximately $9.5 billion in operating cash flow while spending around $1.1 billion on capital expenditures, which was very similar to last year’s results. If the company pays out the same amount in dividends for 2019 as it did for the first quarter, then the payout ratio will be approximately 85%.
While an elevated dividend payout ratio can be a cause for alarm, Philip Morris has managed to keep its levels fairly consistent in recent years. Due to the high levels of free cash flow the business creates over the course of the year, we feel the company’s dividend yield is relatively safe.
Expected returns
Shares of Philip Morris closed at nearly $84 on May 8. Using the company’s expected adjusted earnings per share of $5.09 for the year, the stock has a forward price-earnings ratio of 16.5. This happens to be our 2024 price-earnings target for the stock. Therefore, we don’t anticipate valuation being a positive or negative addition to annual returns over this time frame.
Therefore, total annual returns for Philip Morris will consist of the following: 5% earnings per share growth and the 5.3% dividend yield.
We expect shares of the company to produce over 10% in annual returns over the next five years. Philip Morris’ stock has returned more than 26% this year, easily outpacing the 15% gain in the S&P 500. Even so, we project at least 10% total annual returns through 2024.
Conclusion
Philip Morris saw its cigarette volumes stabilize in the first quarter. While flat year-over-year sales for a company’s primary product is not impressive in a vacuum, this performance was much better than declines seen in previous quarters. The company’s reduced-risk products continue to produce high levels of growth and should see revenues double over the next several years.
This growth should help support a very generous dividend yield and likely lower the stock’s payout ratios. As a result, Philip Morris International is one of the best high-yield dividend stocks for 2019.
Disclosure: I am not long any stocks mentioned in this article.
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