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Summary

  • Current valuation has priced in ~5.5% dividend per share growth.
  • Given my free cash flow forecasts, PM can sustain a ~6.5% dividend per share growth.
  • Actual dividend per share growth will depend on management's decision on free cash flow and earnings dividend payout ratios.

The share price of Philip Morris (NYSE:PM) has risen by 10% over the past 3 months, outperforming a 4% gain for S&P 500 Index. At ~$88, the share price has priced in a dividend growth rate of approximately 5.5% based on the Gordon Growth Dividend Discount Model with current annualized dividend of $3.76 and 10% cost of equity as inputs (see chart below). In this article, I will provide readers some perspectives on whether PM can achieve the implied dividend growth expectation in the next few years.

I have performed free cash flow projections from 2014 to 2016 to gauge PM's capacity for future dividend growth. My analysis started with consensus revenue estimates which predict the top line to grow by 4.2% CAGR from $30.0B in 2014 to $32.6B in 2016. As PM was able to maintain a steady operating cash flow margin in the past 5 years, I assumed a flat margin of 32.5% through 2016, which is consistent with its 5-year historical average. I then put down a flat capex of $1.4B through 2016, which is 12.5% higher than the actual level in 2013. Based on those assumptions, free cash flow was projected to increase by 4.9% CAGR from $8.4B in 2014 to $9.2B in 2016 (see chart below).

For annual dividend payment, I assumed the figure to grow by 6% in 2014 and decelerate to 5% in both 2015 and 2016 (reasons discussed later). In this case, free cash flow dividend payout ratio will increase from 64% in 2013 to 72% in 2014 and stay flattish throughout the forecast years. After paying out dividends, PM would have approximately $2.3B-$2.6B excess free cash flow in each year which will likely be spent on share repurchase given management's commitment to return capital to shareholders. Owing to the increasing dividend obligations and modest free cash flow growth, funds available for share buybacks would decrease from previous years (see chart above).

Assuming 90% of the excess free cash flow is spent on buying back shares and the repurchase price increases by 7.5% per annum from $88, I estimated that average share count will drop to 1.5B by 2016. Given my dividend payment projections, dividend per share was projected to grow by 6.5% CAGR from $3.85 in 2014 to $4.36 in 2016. Comparing with consensus EPS estimates, my dividend per share forecasts imply that earnings dividend payout ratio will increase from 68% in 2013 to 74% in 2014 but then gradually decline to 71% in 2016 (see chart below).

I believe my dividend forecasts are within sustainable range given the following 3 reasons:

  • Free cash flow dividend payout ratio will trend steadily in this scenario, though the metric will be higher than the level in previous years;
  • Earnings dividend payout ratio will initially increase in 2014 but decline in 2015 and 2016; and
  • The forecast dividend per share CAGR of 6.5% is in line with PM's consensus long-term EPS growth estimate of 6.9%, meaning that the earnings dividend payout ratio will stabilize at some level over a long run.

The following table shows a quarterly breakdown of my annual dividend per share forecasts. It should be noted that these forecasts are on sustainable basis. Actual dividend growth could be higher if management is willing to accept higher free cash flow dividend payout ratio.

(click to enlarge)

In conclusion, the share valuation seems to have priced in a dividend growth scenario that is lower than the level that PM can sustain over a long run, which adds a safety margin to the current share price.

All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Source: Philip Morris: What Would Be The Sustainable Dividend Trend?