Philip Morris: Time To Lock In 4% Yield?

| About: Philip Morris (PM)

Summary

Philip Morris raised its dividend by 2%, bringing its annual dividend yield to 4.22%, causing us to ask, "Is now the time to buy?".

While its revenues have slipped, there are encouraging patches of growth in its portfolio, particularly among reduced risk products.

Even so, Philip Morris’ stock is a bit expensive relative to the market and its expected earnings and we recommend that investors wait for the stock to fall to lower.

Analysis

Philip Morris Raises Its Dividend by 2%. Philip Morris International (NYSE:PM) just raised its quarterly dividend by 2% from $1.02 to $1.04 per share, bringing its annual dividend payout to $4.16. This is the ninth straight annual dividend increase for the world's second-largest tobacco maker, although it also happens to be one of its lowest increases since it listed in 2008 - its average dividend yield has increased by an average of 10.7%.

This move brings Philip Morris dividend yield to 4.22%. Thus, investors who buy $10,000 worth of Philip Morris' shares can expect to receive approximately $422 in passive income. This yield is about double the current yield on the S&P500, which counts Philip Morris among its components. It is also among the best yields for tobacco stocks.

The dividend increase disappointed some analysts who'd been expecting a 5% dividend increase but some also view it as opening up the possibility for share buybacks since less cash used for paying dividends means money left over that could be devoted to share repurchases.

In any case, investors who are interested in adding Philip Morris to their portfolios should be aware that they can catch the quarterly dividend if they acquire shares by September 25; the stock goes ex-Dividend on September 26.

Considering this, there is a timeliness to investors' decision to buy Philip Morris shares - so the question for investors is whether now is the time to buy the stock. Let's take a look:

Dividend and Outlook. Before anything else, investors should take note that Philip Morris International is the global company that sells Marlboro and other cigarette brands outside of the United States and China. Philip Morris' US operations are under the umbrella of Philip Morris USA, which is the tobacco division of the Altria Group (NYSE:MO). Meanwhile, it simply licenses its Marlboro brand to China National Tobacco Company, rather than selling its product directly in the mainland.

Philip Morris shares are up by 12.2% in the year-to-date, with investors looking to own the stock due to its high dividend yield and immunity to the soft global economy. After all, while the health risks of smoking cigarettes remains, those who choose to smoke do so regardless of the current state of their respective economies.

Despite extensive negative media coverage and government regulations aimed at reducing tobacco use, worldwide cigarette consumption has actually increased in the last 30 years, though recent years have seen a slight softening of demand and Philip Morris itself saw its organic cigarette volumes decline by 4.8% in the second quarter. Its second quarter weakness was due to lower volume sales in key markets such as Pakistan and the Philippines. Fortunately for Philip Morris, higher pricing and narrower pricing gaps between its higher and lower-end products in some markets (such as Turkey and the Philippines) has helped to soften the blow of lower volume sales and its net revenues declined by just 3.1% during the period.

Going forward, Philip Morris expects its cigarette volumes to decline by anywhere from 2% to 2.5% this year, which is right around what it experienced in 2015. For a large entity like Philip Morris, this is essentially a sideways movement - but it's worth noting that this run counters to industry-wide performance, which has been moderately positive.

Notwithstanding, any improvement in Philip Morris' revenues will be the result of higher pricing and favorable sales mix. Although we noted that nominal cigarette consumption has climbed in the last 35 years, it has actually declined on a per capita basis - to wit, in 1980, average per capita consumption was around 1 cigarette per person per year. By 2015, it was around 0.79 per person per year.

That being said, there are areas where Philip Morris' performance is encouraging. In particular, it is experiencing strong growth in the Japanese e-cigarette market (thanks to its iQOS platform), where it nearly tripled its market share in Reduced Risk Products (i.e. cigarette substitutes that present lower individual health risks) between the ends of March and June.

Its success in attracting new smokers in Japan through iQOS has been replicated in other markets such as Italy and Switzerland and Philip Morris now expects to have iQOS in around 20 markets by the end of 2016. While iQOS will serve only a fraction of its customers, it is nevertheless a lucrative product for Philip Morris since it carries higher prices and margins - for example, an iQOS starter kit sells for approximately $87, while a pack of HeatSticks (which contain the tobacco heated by the iQOS vaporizer) costs $6.00. In contrast, anyone can take up smoking at an average cost of $4.15 per pack.

Investors who are concerned about the sustainability of Philip Morris' dividend shouldn't be. The company currently has an A2 credit rating with Moody's and an 'A' credit rating with S&P, both of which are upper medium grade ratings. That is, the probability of default is between 0.28% and 2.11%, which is quite low.

These lofty ratings shouldn't surprise anyone since Philip Morris currently has $1.26 of working capital for every dollar of its short-term liabilities. Meanwhile, the company's total debt is just 2.4-times its EBITDA, which means that the company's annual cash flow is sufficient to retire all its debt in less than three years. In short, Philip Morris has more than enough liquidity and cash flow generation to continue making $1.6 Billion in quarterly dividends.

That being said, we don't believe that Philip Morris' decision to push forward with a low dividend increase augurs a return to share repurchases. Despite its strong cash flow generation, the company has an equity deficit and we believe that its decision to abstain from a large credit increase is more aligned with S&P's reasoning behind its decision to revise its ratings outlook for the company from 'stable' to 'negative.'

After all, a strong dollar could have an adverse impact on Philip Morris' revenue and earnings (both of which are derived from multiple 'non-dollar' markets), thus reducing its effective cash flow generation even as its debt servicing and dividend payments remain in US Dollars. Thus, in a scenario where the dollar ate a significant portion of its international earnings, where would Philip Morris find the funds (short of issuing more debt) with which to repurchase shares?

Together with its second quarter earnings update, Philip Morris raised its 2016 earnings guidance by $0.05 per share to between $4.45 to $4.55 per share. At the mid-point, this represents 1.8% earnings growth from a year earlier, which is right in line with the S&P500's expected earnings growth (2.1%) for 2016. In that sense, Philip Morris' current earnings multiple of 23.6-times is reasonable since it is slightly lower than the 25-times earnings multiple of the S&P500.

Meanwhile, Philip Morris is currently trading at 20-times its forward earnings estimate, which is modestly higher than the 18-times earnings multiple for the S&P500. The current consensus estimate is for Philip Morris to earn $4.91 per share next year, implying earnings growth of 9%, which is lower than the 14% earnings growth expected for the S&P500 next year.

That being said, there is skepticism that the S&P500 will actually see such a lofty growth rate - while Philip Morris has missed analyst estimates for two straight quarters so an argument can be made that Philip Morris forward multiple should remain where it currently is.

We anticipate that Philip Morris will see just 5% earnings growth in 2017 so maintaining its current forward multiple would mean a price target of $94.90 per share, which is around 4% lower than the current market price and 10% less than analysts' price target.

Conclusion

Our personal reservations regarding the merits of smoking aside, we believe that Philip Morris is a good stock for dividend investors to have in their portfolios. Among other things, the company has globally-recognized brands, robust pricing power and revenues that are likely to be enhanced greatly by its latest product offering (iQOS). These positives are buttressed by its strong credit and excellent cash flow generation.

Even so, we feel that Philip Morris is a bit overpriced at its current level. Therefore, regardless of the immediacy of Philip Morris' next quarterly dividend, we believe that investors should wait until its shares fall to the $90-$94 range before going into the stock. In our view, the market got ahead of itself in bidding up the stock to its current level and, while investors would be giving up an easy 1.055% yield pick-up, it's a small return that doesn't actually provide much of a buffer if the stock falls to the price level that we expect.

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.

Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.