Another Article On Philip Morris? Yes... But Let's Look A Little Closer At Cash Flows

| About: Philip Morris (PM)

Summary

Addictive products provide generally secure future cash flows.

Tobacco products are on a long-term secular decline.

PM has enjoyed cash-rich years, but future years will likely not be so cash generous.

A number of recent articles have taken a look at Philip Morris (NYSE:PM) dividend. I thought I might take a slightly different approach to the question of dividend sustainability.

Dividend History

A good place to start is the dividend history, particularly as compared to a benchmark. This will tend to reflect management's commitment to their dividend. Unfortunately, PM, since the spin-off of MO, only has a dividend history going back to 2Q 2008 (8 years)

The dividend per share for the S&P 500 and PM seems to almost perfectly overlay each other. In fact, the total dividends collected per share over this 8-year period are almost identical at $25.82 for PM and $25.72 for the S&P 500. But let's look at growth trends.

This graph goes back in rolling 4-quarter intervals, with the most recent 4 quarters of dividends compared with the 4 quarters of dividends immediately preceding it. Here the differences become clear. The rolling 4-quarter dividend for PM is slowing sharply. This is the first real danger sign for PM dividend sustainability.

11-Quarter Cash Flow Trends

It is important to remind ourselves very so often that dividends are paid in cash from company operations, not the change in share price, earnings or other derived non-GAAP creations used to support someone's preconceptions. So a good place to start examining a company's cash flow trend is to look at the trend in revenues, cash flow from operations (CFFO) and dividends paid; all per share.

This graph totals a rolling 4 quarters of revenues, CFFO and distributions, dividing each 4-quarter period by a total of the average fully diluted shares outstanding over the same 4-quarter period. Using a rolling 4 quarter total helps take out the peaks and valleys inherent in quarterly cash flows and provides a much better picture of trends. Here, I'm using a log base 2 for the Y-axis to better see the trend in the smaller values. The graph clearly shows the gradual decline in revenues per share and the fluctuation in CFFO per share. Improving CFFO/share while revenue/share declines will happen when management 'tightens-up' expenses and operates the business more efficiently. It is also affected by the financial effect of the exchange rate of foreign currencies or a change in government tax rates; both of which the management has no control over. The decline in revenues per share may also be blunted by share buybacks, which PM has employed with excess cash over the period 2008 through 2013, but has not repurchased any shares in the past 12 months. Some might argue that share buybacks are a way of masking declining revenues. I would argue that in the case of PM, share buybacks are way of managing a long-term secular decline in revenues. But an improvement in CFFO/share over the past 6 quarters is a favorable indicator.

This chart shows the relationship between the dividend and the operational cash available to pay the dividend, or the dividend to CFFO payout ratio (POR). As can be seen, the POR has been improving over the past year-and-a-half, dropping to 72% over the past 4 quarters. This is a bit high for a C-Corp, but good for a tobacco company.

This kind-of-busy chart shows the change in the interest expense over the past 11 quarters (Y2 Axis) and also the percent the interest expense is of CFFO before interest is deducted (i.e. CFFO + Interest expense) (Y1 Axis). At around 10% of CFFO + Interest, this is a low interest expense… although with the addition of about $1.5B in new net debt over the past 12 months, the interest expense has jumped back up following 4 consecutive quarters of decline. Others have shown concern over PM's debt. I'm not concerned at all.

The last CF chart I find useful is a quarter-by-quarter measure of "Discretionary Operational Cash." This is the CFFO that is available to management after all operational expenses are paid, all dividends are paid and all investing activities (CFFI) are paid. It is the discretionary cash management has available to do usually a mix of things like pay down debt, buy back stock, increase cash holdings or payout a special dividend. Over the past 11 quarters, PM has generated (in $millions) $21,701 in CFFO, paid $4,312 in CFFI (including CapEx) and paid out $16,775 in dividends, leaving $614 to do other things with.

Conclusion

I am not at all concerned about PM dividend sustainability over the next several years. The decline in revenues is of concern, but minor concern. Tobacco stocks have the enviable advantage of dealing in a product to which its customers are, for the most part, addicted. So even with a long-term secular decline in tobacco product sales, the future cash flows are about as assured as any future product can be. Certainly, governments overseas could make tobacco sales more difficult or governments could increase excise or other taxes, taking a bigger bite out of the future cash flows. But governments have a perverse interest in seeing sales of cigarettes increase as their excise taxes will be based on sales. This gives management more flexibility in managing to support the dividend, particularly when insiders are holding over 3.3 million shares of PM. The strategies they will use I know not… nor does anyone else. But a dividend cut would not only reduce dividends to insiders, but would send the share price on a quick trip to the basement. Ain't gonna happen.

My principal concern with PM is dividend growth, which will almost certainly be slowing. Low-single digit annual growth may well be on the horizon. Some may see this as enough of a threat to sell PM and go elsewhere. With a current yield of about 4%, the income investor holding this in an IRA may wish to sell/replace at least of part of their PM holdings, while those holding PM in a taxable account will have to consider the tax bite and what replacement yield will be required to replace the lost PM dividend after paying the tax.

But for me... I think I'll stay put for now.

Disclosure: I am/we are long PM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.