PM - Philip Morris: More Profits Could Mean A Dividend Hike In September

Summary

• Philip Morris has paid a rising dividend for as long as it has existed as an independent company -- since the spin-off in 2008.
• The growth rate has been fairly slow in recent years owing to unfavorable currency movements and heavy investments in IQOS.
• Profits from the legacy business are still strong, and in addition, IQOS is now really paying off and looks set to grow for many years to come.
• In addition, the likely acquisition of Swedish Match will add a further avenue of growth.
• Investors can expect this growing company to offer a 5%+ dividend hike in mid-September.

Philip Morris ( PM ) is probably not seen as the most innovative company nor a company that has done much positive for human health. In the old days that was true, but that old perception should be changed. Since 2008 this company has spent more than $8 billion on research into Reduced Risk Products, doing more than most organizations to switch people over from dangerous traditional cigarettes and into lower risk ones. Investing in the economy, creating high-quality research jobs and improving human health -- this is beginning to sound like an ESG investment!

What's good for investors is that not only is this company starting to do a lot of good, they are making tons of money -- and more of it almost every year. In the last quarter it reported adjusted net revenues growth of 6.2%. It looks very much like the slow growth period of the last decade is now in the rearview mirror and that the good old days of double-digit growth is back in earnest.

The stock chart above would be in the less impressive category. Over the last five years the stock is down 18.3% or about $21. Adding in an average annual dividend of around $4.50 over the period the total return is basically flat in the last five years. Unimpressive when compared to most alternatives. I think the best news to glean from this is that the above chart is history, which means mediocre historical returns make for a more auspicious entry point for new investors.

Historical Dividend Growth

Dividends -- and the growth of them -- have been at the heart of the investment case for Philip Morris both before and after the spin-off in 2008. The dividend has grown every year since then, at first aggressively and in later years much less so.

Over the long term, since 2008, investors have enjoyed an annual average growth rate in the dividend of a full 8%. The heyday was back in 2011 when it was raised by 20.3%. Five years ago the quarterly dividend was at $1.04 while it is currently at $1.25 . That is a 20% total increase or 3.7% on average per year. Probably a tad higher than most people's wage growth over the period but that's about it. The reason for the tepid growth rate as of late has been an almost continuous rise in the U.S. dollar, the long-term volume headwind in the traditional cigarette space and fairly heavy investments into Reduced Risk Products (RRPs), most notably IQOS. There has still been ample cash to distribute, just not such a strong growth in cash flow as the company had before. The good news is that with most of the heavy investments already done and with a dollar that is as strong as it is, many of the headwinds will likely turn into tailwinds in the years ahead.

The slow-growing dividend is evident from the chart above, the only exception being the slightly bigger jump of 6.5% in 2018. This was due to the U.S. tax cuts of that year. Still, it says something when a "good year" produces only a 6.5% growth rate.

The payout ratio has been oscillating between 82% and 110%. It is currently close to the lowest level seen in the last five years. Not that I would call 85% low, but in this business a payout ratio of 85-90% is sustainable due to the low volatility of cash flows. Even so, it is clear that future growth must come from increasing earnings and not via an increase in the payout ratio. I would expect the Board to refrain from increasing the payout ratio too much in coming years, just to have more leeway in bad years.

September Dividend Hike

September is the month the increased dividend is announced if we overlook the somewhat eager June announcement in 2018. The company has been so kind as to announce on its website under the dividend section, which date the dividend will be declared. September 14 is the date. Please note that no increase is promised for this date, just that a dividend will be announced, though history tells us this is the time of year it has always been hiked.

The question is how much the dividend will be increased. There's certainly a lot happening with this company at the moment. Last summer things seemed to be getting back to normal, with the Board announcing a new share repurchase program , which it hadn't had for years. Finally, after years of investment and a strong dollar, cash flows were strong enough for both dividend growth and share repurchases. Then in May of this year, an offer for Swedish Match ( OTCPK:SWMAF ) was made, and the share repurchase program was duly canceled. If the deal is completed, it will obviously reduce free cash flows in the short term but it will also give Philip Morris a leading high-growth company within Snus. $16 billion is certainly a lot of money, but remember that it was planning to spend up to $7 billion on share repurchases alone over the next three years. With that canceled, only $9 billion left is needed. Some of it can be funded by remaining free cash flow from the 15% of retained earnings, some more debt that can be paid down over time, and some via the cash flows generated from the newly acquired and profitable Swedish Match. The potential revenue synergies should also be significant over time, with the opportunity to use Philip Morris's distribution channels and regulatory know-how around the world. The acquisition is not cheap, but seems to be fairly valued and it will give Philip Morris one more leg to stand on in the non-smokable segment.

In its latest earnings release , the company reported solid, but not spectacular, numbers with currency-neutral earnings growth of 5.6%. The good news is that the company is confident enough to guide for a currency-neutral EPS growth rate for 2022 of 10% to 12%. Other good news is the fact that this is one of few tobacco companies enjoying positive volume growth with a reported number of 1.1% in the second quarter and 2.2% in the first half. Much of this is thanks to the stellar performance of IQOS. I will have to say that it is quite extraordinary for an industry as conservative as this one, to have a relatively newly invented product category constituting 29.9% of revenues, as was the case for smoke-free products at Philip Morris in Q2. All told, both reported numbers and the guidance were quite strong so there is no question the dividend will be raised.

For 2021 the pro forma adjusted diluted EPS, ex-currency was $5.53. As this is the number the company itself focuses on in its earnings report on page 4, this is the number I will use. It guides for a growth in this number of 10% to 12% in 2022 compared to 2021 for an EPS of $6.09 to $6.20 for a midpoint of $6.15. Using the last number the payout ratio would be 81.3% with the current dividend. If we look at things conservatively, it is likely that the Board would hold off a little bit given the situation in Ukraine and the possible acquisition of Swedish Match. If there is one thing they want to avoid, it is to have to cut the dividend a couple of years hence because they were biting off too much this year. They are thus likely to want to keep the payout ratio well below 90%. If they increased it by 5 cents per quarter the payout ratio would be 84.5%, pretty much in line with recent history in the graph above. Although the increase would only be 4%, in dollar terms it is equal to last year's increase and at about the level investors have become accustomed to in recent years.

On the more optimistic side, there are certainly arguments to be made for a somewhat higher increase. Theoretically, a 10% increase could be within reach as this is the minimum amount the Board expects earnings to increase by. That would bring the annual dividend to $5.5 and would bring the payout ratio to 89.4%. Certainly possible but I see few reasons why the Board would go so far. Nobody expects such an increase and it would leave the company more vulnerable if adverse events occurred.

I think the Board will choose to go for a balanced approach this year, between the minimum amount expected of them and the maximum EPS growth could reasonably support. A 7 cent increase for a new quarterly dividend of $1.32 would represent a growth rate of 5.6% and a new payout ratio of 85.9%. This is a fair balance between offering investors a decent growth in their incomes and leaving some headroom for future years. I therefore think the Board will go for a new quarterly dividend of $1.32 .

Risk Factors

There are numerous risk factors for tobacco companies, unfortunately. An obvious one is the long-term decline in smoking rates most places in the world. Even with strong pricing power, over time the base from which revenue is derived will be smaller and thus more fragile. IQOS and other initiatives are seeking to reduce that risk by finding new avenues of volume and profit growth. Although it seems like a success so far, all such changes entail risk. Another factor which has really come to the surface as of late, is geopolitical risk. I don't think anyone last year thought Philip Morris would announce its exit of the Russian market less than a year later. Yet, here we are . Russia has been generating healthy profits from the legacy cigarette business but has also contributed materially to the growth of IQOS. Luckily, in a way, Philip Morris doesn't operate in the other large market probably most at risk of being embroiled in an economic war: China. That is to say, the majority of this risk is historic. Lastly, a recurring theme for Philip Morris has been the strong dollar. And after years of strengthening, it shows no signs of weakness yet. This means foreign earnings will be lower when translated into U.S. dollars when the dollar rises. Over time, though, currency movements should mostly cancel out.

Current Valuation

Before making an active buy or sell decision, I like to look at valuation multiples compared to peers. As peers I've chosen two major tobacco companies operating internationally, namely British American Tobacco ( BTI ) and Japan Tobacco ( OTCPK:JAPAY ).

Source: Seeking Alpha

Right away we can see that Philip Morris is the most expensive of them all on all three metrics. On Price/Sales it is almost twice as expensive as the number two on the list. As for Price/Earnings it is not quite so extreme but the company is by far more expensive than the other two. The dividend yield is more even with Japan Tobacco and British American both at 7.0% and Philip Morris a fair bit more expensive at 5.3%. That said, they all offer more than generous yields.

None of these are prohibitively expensive but Japan Tobacco is downright cheap with a P/E ratio well down into the single digits. I think I will have to carve out some time to look deeper into this one in the near future. Though Philip Morris is the most expensive of the three, I still think a P/E ratio well below 20x for a global leader is on the cheap side.

Analysts on Wall Street expect Philip Morris to deliver an average annual EPS growth over the coming years of 7.1% . Assuming no change to the already undemanding earnings multiple and adding in the dividend yield of 5.3% we arrive at an expected annual total shareholder return of 12.4%. This is comfortably above what the market as a whole has delivered over time. Furthermore, you get this from a globally diversified company that is also leading the industry into the future. The defensive characteristics are also important to highlight, especially in the current uncertain economic environment. Dividend growth investors who do not already have some Philip Morris in their portfolios should definitely add some.

Conclusion

Philip Morris has paid a rising dividend ever since becoming an independent company in 2008. In recent years, the growth rate has been unimpressive with unfavorable currency movements and heavy investments. The investments are starting to pay off, however, and further growth is in store from IQOS as well as the likely acquisition of Swedish Match. Investors can expect the Board to announce a 7 cent dividend increase in mid-September. Dividend growth investors should definitely make sure they have some Philip Morris in their portfolios.

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