High-Yielding Philip Morris Positioning For Long Haul

Summary

• Philip Morris International Inc is a rock-solid income generation opportunity with strong forward-looking dividend coverage, in our view.
• The company's outlook is supported by surging sales of its alternative tobacco products, with an eye towards its IQOS offering.
• Philip Morris is a tremendous free cash flow generator and ongoing improvements in its cost structure further supports its outlook.
• Management increased Philip Morris' full-year guidance for 2021 during the company's latest earnings report.

Photo by Neydtstock/iStock via Getty Images

By Callum Turcan

Tobacco companies have been in the headlines recently as the Food and Drug Administration (‘FDA’) is reportedly moving to ban menthol cigarettes and flavored cigars in the US. With that in mind, please note that Philip Morris International Inc (NYSE:PM) is not exposed to this event in any meaningful way. In our view, Philip Morris is a rock-solid income generation opportunity with strong forward-looking dividend coverage. Shares of PM yield a nice ~5.1% as of this writing.

Back in 2008, Philip Morris spun off Altria Group Inc (MO). The move separated the international business (Philip Morris) from the US business (Altria) that is behind the popular Marlboro brand and various other tobacco brands. The two companies have been working together on marketing Philip Morris’ IQOS heated tobacco unit (‘HTU’) offering in the US during the past couple years, selling alternative tobacco products that have already received approval from the FDA.

Sales volumes of traditional cigarette products are on a secular decline worldwide; however, given the inelastic demand curve for most tobacco products, pricing power has helped the industry offset those headwinds to varying degrees. As the Marlboro cigarette brand is the most popular brand in the world (outside of China), Philip Morris has ample pricing power, but there is more to the story.

The company is also a leader in alternative tobacco products that replicate the traditional cigarette smoking experience, including its IQOS offering (and the related HEETS HTU insert) which first launched back in 2014. Pricing power at its traditional cigarette business has helped Philip Morris navigate the ongoing secular decline in traditional cigarette sales volumes, while ongoing growth in alternative tobacco sales volumes continues to offer the company a way to potentially grow its revenues and ultimately free cash flows over the long haul.

Image Shown: Philip Morris has been steadily growing its alternative tobacco product sales during the past several years and its growth outlook on this front is quite bright. RRP stands for reduced-risk products according to Philip Morris. Image Source: Philip Morris – First Quarter of 2021 IR Earnings Presentation

Earnings Update and Guidance Boost

On April 20, Philip Morris reported first-quarter 2021 earnings that beat both consensus top- and bottom-line estimates. The company raised its full-year guidance for 2021 during its latest earnings update in large part due to ongoing strength at its HTU offerings, which includes its IQOS and related products. Now, Philip Morris expects to ship 95-110 billion HTU units this year, up from its previous forecast of 90-100 billion HTU units.

Greater economies of scale, pricing power, and past initiatives aimed at improving its cost structure are expected to drive Philip Morris’ adjusted non-GAAP operating margin higher by ~200 basis points this year, up from previous forecasts. The firm expects its adjusted non-GAAP diluted EPS on a constant currency basis to grow by 11%-13% in 2021, hitting $5.75-$5.85, aided by “a gradual improvement in the general operating environment” and various other factors according to the earnings press release.

Ongoing vaccine distribution efforts should enable public health authorities to eventually get the coronavirus (‘COVID-19’) pandemic under control, and Philip Morris’ guidance incorporates its expectations that quarantine measures in key geographical markets will ease during the second half of 2021, though nothing is for certain.

Image Shown: Philip Morris boosted its full-year guidance for 2021 during its latest earnings report. Image Source: Philip Morris – First Quarter of 2021 IR Earnings Presentation

As one can see in the upcoming graphic down below, unit volume growth at Philip Morris’ HTU offerings has simply been stellar over the past several years with ample room for upside going forward. In the first quarter of 2021, the company’s total unit volumes were down just under 4% year-over-year, though its HTU offerings posted unit sales growth of roughly 30% year-over-year.

Image Shown: Philip Morris’ HTU sales volumes, led by growth at its IQOS offering, have grown at a brisk pace of late. Image Source: Philip Morris – First Quarter of 2021 IR Earnings Presentation

News regarding a more restrictive regulatory landscape for US tobacco companies could benefit Philip Morris by supporting sales of its IQOS offering, given that the product is marketed as an alternative to traditional cigarettes. By 2025, Philip Morris aims to generate the majority of its sales from “smoke-free” products (see graphic at the very top of this article). During the company’s latest earnings call, management noted (emphasis added):

Most impressive was the continued strong growth of IQOS, which made up 13% of our volumes and 28% of our net revenues compared to 21.7% in the prior year quarter. We continued converting adult smokers at a very good pace and reached an estimated total of 19.1 million users, of which 14 million have switched to IQOS and stopped smoking. HTU shipment volumes grew plus 30% compared to the prior year quarter with record market shares in key IQOS geographies, 12 markets with double-digit national share and the share of 7.6% overall in IQOS markets excluding the U.S…

Gross margin expansion was also accompanied by strong SG&A efficiencies with our adjusted marketing administration and research costs 200 basis points lower as a percentage of net revenue on an organic basis. This reflects the ongoing digitalization and simplification of our business processes, including our IQOS commercial engine and more efficient ways of working. We delivered around $60 million towards our '21-'23 target of $1 billion in gross SG&A savings before inflation and reinvestments. The pandemic also impacted SG&A costs in the quarter through the later timing of certain projects and reduced commercial and overhead costs due to ongoing restrictions. These latter factors accounted for around $100 million of the organic improvement. -- Emmanuel Babeau, CFO of Philip Morris

The executive suite appears confident that Philip Morris’ organic revenues and adjusted operating margins will continue to move in the right direction going forward. We view Philip Morris’ cash flow growth outlook quite favorably, especially as the world begins to emerge from pandemic-related lockdowns.

Financial Update

Philip Morris forecasts it will generate ~$11.0 billion in operating cash flow this year at exchange rates seen recently, before taking year-end working capital movements into account, while spending ~$0.8 billion on its capital expenditures (this guidance did not change from its previous forecast). Based on its current guidance, Philip Morris expects to generate around $10.0 billion or more in free cash flow (defined as net operating cash flows less capital expenditures) this year.

The firm's free cash flow generating abilities continues to impress. Philip Morris generated ~$8.8 billion in annual free cash flow on average from 2018-2020, exceeding run-rate dividend obligations of ~$7.4 billion at the end of 2020.

The company exited March 2021 with a net debt load of roughly $25.5 billion (inclusive of short-term debt), which weighs negatively on its forward-looking dividend coverage. However, Philip Morris has ample liquidity on hand ($3.9 billion in cash and cash equivalents on the books at the end of last quarter) and a reasonable leverage ratio. At the end of March 2021, its net debt to adjusted (non-GAAP) EBITDA ratio stood at ~1.9x. As an aside, Philip Morris’ ‘equity investments’ line-item is primary represented by strategic assets. That figure stood at $4.6 billion at the end of March 2021, though we would not consider these assets to be “cash-like” in nature.

Explaining the Dividend Cushion Ratio

At Valuentum, we have a proprietary way of gauging the forward-looking payout strength of any given company with an established track record which we refer to as the Dividend Cushion ratio. Here we will provide a quick overview of how this ratio is formulated and why it is such a useful tool for investors.

Using our enterprise cash flow valuation models, we forecast the relevant firm’s future free cash flow (again, defined as net operating cash flow less capital expenditures) performance into perpetuity. A company’s free cash flows are the funds that are left over after it reinvests back into the business for both maintenance and growth. They can be used to organically pay dividends (or buy back stock or pursue acquisitions, for example). Funds raised from divestment proceeds, on the other hand, are one-off sources of cash proceeds and do not represent a sustainable way of generating funds to maintain dividend payouts over the long haul.

Image Shown: From purely a forward-looking financial perspective (we also take into consideration qualitative dynamics), we assess the safety of a firm's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in the Dividend Cushion ratio. A Dividend Cushion ratio significantly above 1 indicates a company can cover its future dividends with net cash on hand and future free cash flow (by our estimates), while a score below 1 signals trouble may be on the horizon. By extension, the greater the ratio, the stronger the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Image Source: Valuentum

For the Dividend Cushion ratio, the numerator is represented by the sum of the company’s forecasted future free cash flows over the next five full fiscal years plus its net balance sheet considerations. Net cash positions are added to the sum in the numerator and net debt positions are subtracted from that sum (only looking at long-term debt here). Our raw, unadjusted Dividend Cushion ratio stress tests a situation where the company in question is locked out of capital markets and must pay off its long-term debt via its (forecasted future) free cash flows. When relevant, we also take a firm’s other non-cancellable future financial obligations into account (such as pension plans and legal liabilities) in the net balance sheet consideration figure.

All else equal, a company with a massive net debt load has weaker forward-looking payout coverage than a company with a massive net cash position, as net cash positions are a source of payout strength (dividend payouts can be funded via that cash pile) while net debt positions force companies to redirect free cash flows away from other activities (such as dividend obligations) and towards paying off those liabilities. The denominator of the Dividend Cushion ratio is represented by the sum of the company’s forecasted dividend obligations over the next five full fiscal years.

Putting everything together, the Dividend Cushion ratio indicates whether a company’s future forecasted free cash flows are expected to fully cover its dividend obligations over the given period or not while keeping its balance sheet considerations in mind. Philip Morris has a Dividend Cushion ratio that is just below parity at 0.8, which would be stronger if it were not for its large net debt load. However, we still view its forward-looking payout coverage quite favorably due to its stellar free cash flows and the high probability that Philip Morris will be able to refinance maturing debt at attractive rates going forward. The upcoming image down below provides a visual deconstruction of Philip Morris' Dividend Cushion ratio.

Image Shown: A visual deconstruction of Philip Morris' Dividend Cushion ratio, which sits just below parity at 0.8. Image Source: Valuentum

Concluding Thoughts

Though we understand that some investors may shy away from the company due to ESG-related considerations, for those that do not have such investment restrictions, we continue to like Philip Morris. The company is a rock-solid income generator with a promising growth outlook. We view Philip Morris' forward-looking dividend coverage quite favorably, though we would like for management to pare down the firm’s net debt load over the long haul.

Historically, the firm has not allocated a significant amount of capital (or any) towards share repurchases, highlighting management’s commitment to income seeking shareholders. Recently, shares of PM have been on a nice upward climb indicating investors continue to warm up to Philip Morris’ promising free cash flow growth outlook, supported in part by its alternate tobacco products (and what they imply regarding long-term resiliency versus traditional cigarettes).

Analyst’s 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. I have no business relationship with any company whose stock is mentioned in this article.

Callum Turcan does not own shares in any of the securities mentioned above. Philip Morris International Inc (PM) is included in Valuentum's simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Neither Valuentum nor any of its affiliates own shares of PM. Contact Valuentum for more information about its editorial policies.