Philip Morris: Near-Term Dividend Growth Potential Is Underappreciated

Aug.25.14 | About: Philip Morris (PM)


Due to healthy free cash flow generation and EPS growth, PM can comfortably support 8% dividend per share growth over the next few years.

The current share price implies a perpetual dividend growth rate of about 5.3%.

A 2-stage dividend discount model suggests the shares are 10% undervalued.

The share price of Philip Morris (NYSE:PM) is currently at 9% below its 52-week high of $92 achieved in July 2014. I believe the recent price weakness presents an invaluable buying opportunity for long-term income investors, as the shares are trading at a notable discount to their intrinsic value. In this article, I will elaborate on my free cash flow and dividend projections to support the buy thesis.

My free cash flow analysis is based on current consensus revenue estimates which predict the top line to grow by 4.1% CAGR, from $29.9B in 2014 to $32.5B in 2016. PM managed to achieve a fairly stable operating cash flow margin in the past 5 years, with an average of 32.5%. To be conservative and account for the fact that the operating cash flow margin was only 26% in the first half, I modeled 30% margin for 2014. For the next 2 years, I assumed a 50 bps expansion in the cash margin, which is based on current market expectation of a 100 bps EBITDA margin expansion over the period. In terms of capital expenditure, I assumed it to be flat at $1.3B throughout the forecast period, which is in line with the consensus estimate. Based on those assumptions, free cash flow was projected to increase by 5.8% CAGR, from $7.7B in 2014 to $8.6B in 2016 (see chart below).

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PM paid dividends of $0.94 in the past 4 quarters. As the company typically raises dividend each year, I would expect a dividend hike in Q3 2014. For this analysis, I assumed an 8% growth in Q3 of the current and next 2 fiscal years. As such, annual dividends between 2014 and 2016 are expected to be $3.91, $4.22, and $4.56 per share, respectively (see the first chart). The sustainability of my dividend growth assumptions will be tested by the following analysis.

Total dividend payments in the forecast period were projected to trend from $6.2B to $7.1B (the projection is based on my average share count estimate, which will be discussed later), and my forecasted free cash flows are sufficient to cover the obligation. In this case, PM will have approximately $1.5B cash surplus in each forecast year. Given the company's track record of returning significant amount of capital through share buybacks, I assumed 80% of the cash surplus to be spent on repurchasing shares. Assuming an average buyback price of $86 in 2014 and 10% annual price step-up, the share buyback will reduce share count by 38M over the forecast period. As mentioned earlier, the share count estimate was used to project total dividend payment for each year (see the first chart).

Under this scenario, the free cash flow dividend payout ratio will rise modestly from 81% in 2014 to 83% in 2016, and the earnings dividend payout ratio will be flat at about 75% throughout the period. This suggests that PM can comfortably sustain the 8% dividend per share growth in the next few years without material increase in cash flow and earnings payout level (see the first chart). However, as consensus view calls for a long-term EPS growth estimate of only 6.5%, the dividend per share growth will eventually need to slow down in order to maintain a steady earnings payout over the long run.

Based on Gordon Growth Dividend Discount Model and 10% cost of equity, PM's current share price of $84 implies a perpetual dividend growth rate of about 5.3% (see chart below). As the implied dividend growth rate is below both my forecasted 8% in the near term and the company's long-term EPS growth potential, the stock is likely undervalued from a dividend investing perspective.

To illustrate the undervaluation, I used a 2-stage dividend discount model to calculate PM's fair value. The first stage assumes 8% annual growth in dividend per share through Q3 2016, and the second stage represents perpetual growth state, with the growth rate of 5.3% implied by the share price. At the 10% cost of equity, I arrived at a fair stock value of $93.2 by summing the present value of all future dividend incomes. The estimated fair value represents an almost 10% upside from the current share price, meaning the current valuation bears a solid margin of safety (see chart below).

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In summary, PM is currently trading below its fair value, as the company's near-term dividend growth potential is not fully reflected by its share price. Since future dividend per share growth is unlikely to slow down to a 5% range in the near term, thanks to PM's healthy free cash flow and EPS prospects, a buy rating is warranted.

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.

Disclosure: The author is long PM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.