Philip Morris: Bullish On Dividend Prospects

| About: Philip Morris (PM)

Summary

Philip Morris’ yield has great appeal, but we think that its dividend growth prospects mark it out as a top notch income play.

The brand strength of Marlboro plus Philip Morris’ exposure to emerging economies will boost its dividends and share price.

Philip Morris’ investment in reduced risk products (RRPs) will also positively catalyse its earnings, share price and dividends moving forward.

With Philip Morris (NYSE: PM) yielding 4.1% right now, many investors may feel that it is a worthy purchase from an income perspective. Sure, with the Federal Reserve expected to raise interest rates by just 25 basis points over the next year, Philip Morris' yield is likely to remain relatively appealing - especially while the S&P 500 yields around 2%.

Further, Philip Morris has strong dividend growth prospects which when combined with its high yield make it a star dividend play in our view. Here are three catalysts which we think will boost Philip Morris' earnings, dividends and share price moving forward.

New products

The tobacco industry is at the beginning of the biggest change in a generation in our view. The popularity of e-cigarettes has caught many commentators by surprise and while it is a fast-growing market which is worth in excess of $3 billion, we think that it forms part of what will become a wider market of reduced risk products (RRPs). In other words, we believe that continued investment in RRPs will lead to a constant flow of new and innovative products which will come in and out of fashion as consumer tastes change.

Philip Morris is well-positioned to take advantage of the growing market for RRPs. Its Marlboro HeatSticks heat rather than burn tobacco, while Philip Morris' tie-up with Altria on RRPs should provide a degree of scale which other tobacco companies struggle to match on their own. This partnership should provide greater resources as well as a lower risk profile due to the costs of development being shared.

And with the two companies operating in different geographies, the rewards from the development of new RRPs will be fully accessible to Philip Morris [and Altria (NYSE:MO)]. This means that there is an asymmetric risk/reward opportunity in terms of risk being lowered and rewards remaining just as high as if Philip Morris went it alone on the RRPs front. In our view, this potential within the RRP space will positively catalyze Philip Morris' earnings, dividends and share price moving forward.

Fast-growing markets

World population is forecast to increase by 35% between today and 2050, with it expected to increase to 9.7 billion in that time. Much of this rise in population will take place in emerging economies and it is in these geographies where Philip Morris operates. This means that even if smoking rates decline in emerging economies as they have done in the US in the last ten years (from 21% of adults in 2005 to 17% of adults in 2014), the absolute number of smokers is likely to offset this.

This provides an opportunity for Philip Morris to grow its earnings and dividends at a faster pace than its US and developed economies-focused rivals. Sure, there is the potential for increased regulation of tobacco products in emerging economies. For example, in Russia smoking restrictions have got tougher in recent years. However, with Philip Morris having exposure to RRPs as well as traditional cigarettes, we think that it will adapt to regulatory change and that its exposure to the emerging world will positively catalyze its dividend growth moving forward.

Brand strength

While all cigarettes are relatively price inelastic, with it being estimated that they are between-0.3 and -0.5, we think that Philip Morris-owned Marlboro cigarettes are more inelastic than any of their rivals. That's because they are the only cigarette brand which regularly features in Forbes' top brands list (at number 26 in 2016). This highlights the degree of brand loyalty which Marlboro enjoys and in our view this equates to significant margin growth potential for Philip Morris moving forward. Sure, volumes may be falling across the global tobacco market, but with the major pricing potential on offer via Marlboro, we think that Philip Morris will be able to offset the declines which are being seen in volumes.

The strength of the Marlboro brand also gives Philip Morris a relatively high degree of stability and resilience. This has allowed it to raise its dividend payout ratio so that it now stands at 97% of earnings. While this may be seen as a risk by some investors who view such a high payout ratio as unsustainable in the long run, we think that Philip Morris' dividend growth prospects are bright because they were covered 1.1 times by free cash flow in the last financial year.

This means that Philip Morris has the scope to fund capex while paying a generous return to its investors. Clearly, dividends may not be able to rise at a faster pace than earnings moving forward, but we think that earnings growth will be sufficiently strong to fund a fast-growing dividend.

Outlook

With the US dollar expected to appreciate versus the euro and a number of other world currencies over the next year , Philip Morris is likely to be hurt by a negative currency translation. While this is disappointing, it is nevertheless a short term challenge in our view which does not change the appeal of the company for dividend seeking investors. We believe that its brand strength, exposure to emerging economies and its exposure to the RRP segment will positively catalyze earnings, its share price and dividends moving forward. Therefore, now is a perfect time to buy it in our opinion.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.