Philip Morris International (PM, Financial) recently raised its dividend. This already high yielding stock has now given shareholders a dividend increase for more than a decade following its spinoff from Altria Group Inc. (MO, Financial). Including when it was part of Altria, the dividend growth streak expands to more than five decades.
Does this increase and the income the stock provides make Philip Morris a buy, even following a 15% gain over the last three months? In this article, we will examine the company's most recent quarter, dividend and valuation to determine the answer.
Quarterly highlights
Philip Morris reported its second quarter earnings results on July 21. Revenue declined 13.6% year-over-year to $6.7 billion, but this wasn't as bad as feared as results were $110 million better than what was expected by Wall Street analysts. Earnings per share decreased 17 cents, or 11.6%, to $1.29, which was 19 ahead of consensus predictions. Currency, as usual, was a headwind during the quarter. Revenue was lower by 9.5% and EPS dropped 7.5% on a currency neutral basis.
Covid-19 had a significant impact on results as consumers were out and about less during the quarter. Less disposable income in many regions also played a role in the decline. This was especially pronounced in urban areas around the world, where Philip Morris has a higher market share.
Volumes for cigarette and heated tobacco declined 14.5%. Cigarette shipments were down 17.6%. The company's market share fell 10 basis points to 28%, but much of this was related to continued weakness in Indonesia and duty free cigarettes.
Source: Philip Morris' Second Quarter Earnings Presentation, slide 18.
Cigarette volumes were down at least double-digits in every region, led by a 28% decline in Southeast Asia, a 20% drop in Latin America & Canada and a 13% decrease in the European Union. These results did improve over the course of the quarter as lockdown restrictions were lessened.
That said, Philip Morris' heated tobacco products nearly offset this weakness. This product category had growth of 24.3% in the quarter. The company has seen these products make up a more meaningful percentage of total volumes.
Source: Philip Morris' Second Quarter Earnings Presentation, slide 16.
In just a few short years, heated tobacco units have grown from an insignificant portion of the company's volumes to a driver of growth.
Heated tobacco products represented 10% of shipment volumes versus 8% of volumes in the second quarter of last year. Reduced risk products contributed almost a quarter of sales. The company estimates that nearly three quarters of IQOS users have quit smoking, turning instead to heated tobacco products.
IQOS, which was approved by the Food & Drug Administration as a modified risk product in early July, had an estimated 15.4 million users by the end of the second quarter. This compared to 14 million users in the first quarter of 2020 and 11.2 million in second quarter of 2019.
IQOS has a commanding market share position in several countries, including in Japan where market share in 20%. The number of users reached 5.8 million. The overall heated tobacco category market share in the country is 25%.
Philip Morris was able to pass along a 3.3% increase in pricing in the combustible category. Due to the work off of inventory builds that took place in March ahead of restrictions related to Covid-19 meant that the company wasn't able to raise prices as had been planned.
Industry volumes strengthened in June, especially in the European Union where margins are often higher. Total volumes shipped were the highest of the year. IQOS momentum for Philip Morris accelerated during this month as well.
The balance sheet looked solid at the end of the quarter as Philip Morris had $17.8 billion in current assets, including $4.2 billion in cash and cash equivalents. This compares to current liabilities of $15.8 billion and $2.6 billion of debt due within a year. Total debt stood at $29.6 billion.
Philip Morris has issued full-year guidance of adjusted EPS in a range of $4.92 to $5.07, ahead of consensus estimates of $4.94. This guidance is based on assumed volume declines of 8% to 10% for the company. Philip Morris eyes 15% industry declines for the full year.
Dividend and valuation analysis
Philip Morris raised its dividend by 2.6% for the upcoming Oct. 13 payment. This is the 13th year in a row that the company has paid a higher dividend than the year before. The company has an average dividend increase of:
- 3.8% per year over the past three years.
- 3.4% per year over the past five years.
- 7.6% per year over the past 10 years.
Dividend growth has really slowed in the short-term. Making up for this is the current yield of 5.9%, which is considerably higher than the 10-year average yield of 4.5%. The stock has never averaged a yield this high for an entire year. Only two years (2018 and 2019) had an average yield above 5%.
Using the annualized dividend of $4.80 and the company's midpoint for adjusted EPS of $5.00, the payout ratio is 96%. The payout ratio has climbed steadily over the last decade as dividend growth has outpaced EPS growth. The average payout ratio since 2010 is 78%, but the expected payout ratio for 2020 would be the highest over this period of time.
The free cash flow payout ratio is also extremely high. Philip Morris distributed $1.83 billion of dividends last quarter while generating $1.79 billion of free cash flow for a payout ratio of 102%. Dividends distributed over the last four quarters totaled $7.26 billion while free cash flow was $7.78 billion for a payout ratio of 93%. The free cash flow pictures looks a little better going back even further, but not by much. Dividends distributed from 2016 through 2019 came to $26.9 billion while free cash flow produced was $31.5 billion for an average free cash flow payout ratio of 85%.
Both the EPS and free cash flow payout ratios are very high. Fortunately for Philip Morris, the company doesn't have much in the way of capital expenditures which were just $140 million in the second quarter and $660 million over the also four quarters. Even interest expense hasn't been a headwind as the company's total was just $162 million last quarter and $785 million over the last year. Therefore, nearly every dollar of free cash flow could be paid out in the form of dividends or share buybacks, which have been paused.
Because of this, I don't feel that Philip Morris' dividend is in danger of being cut, but a severe downturn in the business could result in one down the road.
Shares of Philip Morris closed Friday's trading session at $81.23. Using the company's EPS estimates for the year, the stock has a forward price-earnings ratio of 16.2. The stock's 10-year average price-earnings ratio is 17.5, while the five-year average is 19.3.
Just as when I reviewed Altria, I feel that declining volumes for smokable products should earn the stock a lower valuation. Products like IQOS are performing well, but they are not yet at the point where they can offset the decrease in traditional tobacco products all on their own.
As a result, I have a target price-earnings range of 16 to 18 for Philip Morris. Multiplying EPS estimates by this range gives us a price target range of $80 to $90. The downside would be 1.5% while the upside could offer a return of 10.8%.
The dividend yields at $80 and $90 would be 6% and 5.3%, respectively. Added to the share price returns at the low and high end of my price target range, shares of Philip Morris could offer a minimum 4.5% and as much as 16.1% in total returns.
Final thoughts
Covid-19 was a major disruption to Philip Morris during the second quarter. The company's cigarette volumes were down at least double-digits in every region that it operates. This changed as the quarter moved along as social distancing restrictions were eased, but are likely to be down at a high rate industry wide for the year.
Heated tobacco volumes, on the other hand, were up by high rates in almost every region. The company is also seeing the transition among its customers from traditional tobacco products to heated products like IQOS. Heated tobacco products also make up a sizeable portion of overall volumes compared to just a few years ago.
Philip Morris' dividend payout ratios are extremely high, but the company's lack of capital expenditures and interest expense mean that the dividend is likely safe, even if future growth could be minimal. Those looking for income will note that the yield is very high compared to the stock's historical average.
At the low end of my valuation range, total returns would be low single-digits, but the total returns could be as high as 16%. I feel that this is a solid risk/reward for Philip Morris and thus rate shares of the company as a buy.
Author disclosure: the author has no position in any stock mentioned in this article.
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