Philip Morris: Downside Is Within 5%

| About: Philip Morris (PM)


PM trades at reasonable valuation relative to both peers and overall market levels.

Current valuation implies 5.5% annual dividend per share growth while PM can sustain about 6% annual growth through 2016.

Price floor is about $80 from a dividend yield perspective.

The share price of Philip Morris (NYSE:PM) has risen by 15% since dropping to its 52-week low of $75.28 in early February, outperforming a 9% gain for S&P 500 Index. In my view, PM stock remains a buy at this level given that the company's solid fundamentals should ensure continued healthy cash flow and dividend growth and price downside is limited by a floor at ~$80.

Management reiterated their EPS growth guidance for 2014 at about 6%-8% in a recent investor meeting. The focus in 2014 continues to be the development of next generation products and launch of Marlboro 2.0 program which would present incremental growth opportunities over a long term. In addition, management will continue to explore better price realization and optimize operating costs through redeployment of manufacturing facilities.

At ~$87, PM trades at 15.4x forward 2015 P/E multiple, which is 3% below the average of its North American tobacco peers (see chart below).

This relative valuation appears reasonable given PM's slightly below-average long-term earnings growth potential but above-average margin and capital return performance. Compared to overall market, PM's P/E multiple is now at 3.5% premium over S&P 500's average at 14.9x (see chart below), which also makes good sense because of PM's higher dividend yield (4.3% vs. S&P 500's average at 1.9%) and above-average free cash flow margin (28%) despite the fact that PM's consensus long-term earnings growth estimate of 7.1% is below the average of 8.9% for S&P 500 companies.

Based on current annualized dividend of $3.76 per share and 10% cost of equity (the CAPM model would result in a 8.7% based on 3% risk-free rate, 6% equity risk premium, and PM's 5-year beta of 0.95), the Gordon Growth Dividend Discount Model suggests that the current price of ~$87 implies a dividend growth rate of slightly less than 5.5% (see chart below).

I have performed a cash flow analysis for PM to gauge a sustainable dividend growth level over the current and next 2 years (see chart below).

Given the company's stable operating cash flow margin in the past 5 years, my analysis was based on consensus revenue estimates which predict the top line to reach $32.6B by 2016. I assumed a flat 32.5% operating cash flow margin through 2016, which is consistent with its 5-year historical average. For capex, the figure was projected to reach $1.5B by 2016. Based on these assumptions, free cash flow was forecasted to grow from $8.5B in 2014 to $9.1B in 2016 at a CAGR of 3.7%. Given my free cash flow projections, I estimated that PM can grow its total dividend payment by 5% per annum over the forecast period while maintain a somewhat flat dividend to free cash flow payout ratio at ~72%. After the sustainable dividend payout, PM would still have approximately $2.5B excess free cash flow per year. Assuming the excess cash is spent on repurchasing shares each year with a 10% growth assumption for share buyback price (e.g. $113/share by 2016), I estimated that total share count would be reduced from 1.62B in 2013 to 1.55B in 2016. In this case, dividend per share would reach $4.27 by 2016, representing a 6.1% CAGR from the actual level of $3.58 in 2013. As such, PM's current valuation would look completely inexpensive from a dividend growth prospective given the implied ~5.5% annual growth.

From a dividend yield perspective, PM's price downside is very limited. Looking at historical data since 2008, PM's yield rarely exceeded 5% except in 2008/2009 global financial crisis (see chart below). Also, a 5% dividend yield for PM would be above current peer average at 4.6% (see peer table above). Hence, assuming 1-year holding period, 6.0% growth for per share dividend in the next annual cycle, and 5% dividend yield ceiling, this scenario would result in a share price of ~$80, implying only 3.5% loss in a year after factoring in the dividend income (4.3%).

In conclusion, given PM's healthy fundamental prospects and that the stock's current valuation reasonably reflects what the company can deliver and sustain over a medium term, investors are recommended to accumulate shares at this level.

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

Disclosure: I am 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.

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