What Should I Do With My Philip Morris Shares, Now That It Is Paying A 6.04% Dividend?

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About: Philip Morris International Inc. (PM), Includes: LYB, MO
by: Mycroft Friedrich
Summary

Quantitative Analysis of Philip Morris shares using the power of free cash flow.

Analysis of Philip Morris from a Main Street vs. Wall Street perspective.

Answers SA Readers question as to "What should I do with my Philip Morris shares, now that it is paying a 6.04% dividend?"

Shows the reader how to do a similar analysis on their own portfolio holdings.

On February 7, 2019, Seeking Alpha's News Editor Clark Shultz reported the following: "Philip Morris +2% after guidance satisfies". Back on January 24, 2019, I wrote an article on Altria (MO) at the request of a subscriber to our Seeking Alpha Marketplace service, asking me to answer the following question:

What should I do with my MO shares, now that it is paying a 7.12% dividend?"

After doing so, many of my readers here on Seeking Alpha asked me if I could do a similar type of article on Philip Morris (PM)? I told them I would, but that I would first wait for the company to report its latest quarterly results. Philip Morris International has done so, therefore, here is the promised article.

Both companies, as you can see from the chart below have had a rough couple of years in terms of stock market performance, especially when compared to the S&P 500 Index (SPY):

These sharp drops in the share prices of both companies can be mainly attributed to slowing cigarette volumes as shown in the linked news article above:

Philip Morris International is up 1.67% after the company knocked out an earnings beat with its Q4 report, despite a 3.1% Y/Y drop in cigarette volume."

Many investors in Philip Morris are mainly invested in it for the strong dividend that the company pays out. Unfortunately, as you can see from the Seeking Alpha dividend table below that Philip Morris has a payout ratio of 86.23%.

For those who don't know what a payout ratio is, here is a great introduction. The closer you get to a 100% payout ratio, the more unsustainable the dividend becomes, and I like to see a 50% or less payout ratio whenever possible, like you see for LyondellBasell (LYB) for example.

In my opinion, the dividend payout ratio is the most important indicator that dividend investors should look to when investing in dividend investments, while the second most important is the company's free cash flow generation. In this article, I will have our Friedrich Algorithm analyze Philip Morris's free cash flow for everyone and see how it comes out. I will not discuss the various operations of Philip Morris and how each is doing, as you can read many such articles on Seeking Alpha, both pro and con. What I will simply do is a quantitative analysis of Philip Morris's results on Main Street and then relate them to what an investor should do on Wall Street, using zero emotion.

Let us now go and analyze Philip Morris and find out what our Friedrich Algorithm has to say about all this.

Main Street vs. Wall Street

In analyzing Philip Morris, we will present some unique ratios that our Friedrich Investing System uses and will present a real-time quantitative analysis that will demonstrate the power of free cash flow in the investment process. In doing so, we will also teach everyone how to analyze one's portfolio holdings on Main Street vs. Wall Street. At the same time, we will explain how the methodology involved in this analysis came about.

Main Street is where Philip Morris operates, and Wall Street is where its shares trade. The Philip Morris shares that one can purchase on Wall Street are traded publicly on exchanges and the company has little control over how each share will trade. Philip Morris is required to release its earnings reports each quarter and, from time to time, it also provides press releases to its shareholders (and the general public) giving updates on how its operations are doing on Main Street.

Main Street is where Philip Morris invests in its own operations and sells to its customers. How well the CEO of Philip Morris and its management do in selling those products determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer (or even just a smartphone), an internet connection, and a brokerage account can buy or sell any stock at any time, expertise is not a requirement in order to invest on Wall Street.

This results in Wall Street being a very dangerous place to operate as many investors tend to invest through emotion or follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus, we have the classic case of "greed vs. panic."

Creation of the Friedrich Algorithm

Having noticed this problem some 35 years ago, I spent the last three decades building an algorithm called Friedrich. Our algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, Mutual Fund, or individual portfolio with the use of our Portfolio Analyzer.

Many years ago, while reading Berkshire Hathaway's (BRK.A) (BRK.B) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett called "Owner Earnings," or what we may consider to be Mr. Buffett's version of FCF, or "Free Cash Flow." To my amazement, in that little footnote, Mr. Buffett explained how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

[Owner earnings] represent [A] reported earnings plus [B] depreciation, depletion, amortization, and certain other non-cash charges… less [C] the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

I have used the free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line sheets for my 60-year backtest of the DJIA from 1950 to 2009.

The backtest mentioned above demonstrated that if one can purchase a company whose shares are selling for 15 (or less) times its Price to Free Cash Flow Ratio, that the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio is calculated.

Wall Street Analysis

Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor / [(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

The above are the ratios I use when analyzing a stock on Wall Street, and below are the ratios I use when analyzing a stock on Main Street.

Main Street Analysis

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

The FROIC ratio tells us how much forward free cash flow we can expect the company to generate on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow it, therefore, has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, Wall Street will eventually take notice.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing Philip Morris' Price to Bernhard Buffett FCF ratio, we must first adjust Philip Morris' Wall Street Price to account for its debt using our Sherlock Debt Divisor. Below is a detailed definition of that ratio and how we use it.

Sherlock Debt Divisor

A major concern that I have these days in analyzing companies is the debt burden relative to its operations and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what I have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well, I take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, I reward it but punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used and the more leveraged a company is, the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for Philip Morris' TTM (trailing twelve months) is as close to real-time data as we can get, based on when each company reports. The current analysis is taken from the Philip Morris September 30, 2018, filing with the SEC (except the Market Price per share).

Market Price Per Share = $76.73

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $18,538,000,000

Total Current Liabilities = $15,599,000,000

Working Capital = $2,939,000,000

Long-Term Debt = $28,179,000,000

Diluted Shares Outstanding = 1,555,000,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/ (Diluted Shares Outstanding))

Sherlock Debt Divisor = $76.73 - ((2,939,000,000 - $28,179,000,000)/1,555,000,000))

Sherlock Debt Divisor = $76.73 - ($-16.23) = $92.96

Since Philip Morris has more Long-Term Debt vs. Working Capital, we, therefore, must punish it and use the new $92.96 as our new numerator in all our calculations.

Wall Street Analysis of Philip Morris

Price to Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/[(net income per share + depreciation per share) - (capital spending per diluted share)]

Sherlock Debt Divisor = $92.96

Net Income per diluted share = $6,695,000,000/1,555,000,000 = $4.30

Depreciation per diluted share = $977,000,000/1,555,000,000 = $0.63

Capital Spending per diluted share = $-1,655,000,000/1,555,000,000 = $-1.06

$4.30 + $0.63 - $1.06 = $3.87

Price to Bernhard Buffett Free Cash Flow Ratio = $92.96/$3.87= 24.02

Now, if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result), you will notice that our result of 24.02 is considered average.

We last ran our data file for Philip Morris on February 7, 2019, and our Friedrich Algorithm gave a recommendation to our subscribers that Philip Morris is a "Hold" as our Friedrich Data File and Chart below shows. There you will also find the last ten years of Philip Morris' Price to Bernhard Buffett Free Cash Flow results.

Main Street Analysis of Philip Morris

Now that we have taught everyone how to calculate our Price to Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) - (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

Net Income per diluted share = $6,695,000,000/1,555,000,000 = $4.30

Depreciation per diluted share = $977,000,000/1,555,000,000 = $0.63

Capital Spending per diluted share = $-1,655,000,000/1,555,000,000 = $-1.06

$4.30 + $0.63 - $1.06 = $3.87

Revenue Growth Rate TTM = 4%

[(($4.30 + $0.63) (104%)) - $1.06 =$4.06

Long-Term Debt = $28,179,000,000

Shareholders Equity = $-11,720,000,000

Diluted Shares Outstanding = 1,555,200,000

FROIC = ((Forward Free Cash Flow)/ ((Long-Term Debt + Shareholders' Equity)/Diluted Shares Outstanding)))

$4.06/$10.58 = 38.37%

FROIC = 38.37%

Now, if one goes to my FRIEDRICH LEGEND again (on what is considered a good or bad result), you will notice that our result of 38.37% is considered excellent and tells good us that Philip Morris produces $38.37 in forward free cash flow for every $100 it invests in total capital employed on Main Street.

On Main Street, Philip Morris is doing great, while on Wall Street it is considered a hold.

What To Do?

Going forward, Philip Morris has negative shareholders equity and that is why its debt of $28.179 billion does not impact its FROIC as much as it would have if it were positive. Relative to its price to Bernhard Buffett free cash flow ratio, Philip Morris is getting quite expensive and could tip over to an overbought condition compared to its current Hold rating. Many strong companies run very successfully with negative shareholders equity, so that is not a major issue, but instead is a concern of which to be aware.

What most investors reading this article want to know: is the dividend safe or not? Well, I believe it is as long Philip Morris does not break the 100% payout ratio threshold.

Now that you have read my Philip Morris article I invite you to read my Altria article as I believe that Altria is a much better investment in a side by side comparison. This is the case even though MO is experimenting with new ways to generate growth such as in the marijuana marketplace, by investing in Cronos (OTC:CRON), and investing in the vapor nicotine marketplace by buying Juul (JUUL). In the end, it is my belief that within a decade, these two companies will dominate the vapor and marijuana markets, as a way to replace tobacco. How big the marijuana or vapor marketplaces will be is anyone's guess.

In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor toolbox in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below.

Disclosure: I am/we are long LYB. 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: This analysis is not an advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.