Philip Morris International Inc. (NYSE:PM) was spun off from MO in 2008, with MO serving the U.S. and PM retaining all international operations. With an industry as simplistic to understand as tobacco, there is temptation to assume that the major players are all similar enough to each other. As you will see, such an assumption is often dangerous.
While PM and MO both heavily rely on the Marlboro brand and maintain dominant market shares in many of their regions, PM has significantly underperformed MO over the last few years.
PM’s stock returned 15.9% per year from 2010-2014 (MO +27%) and 5.5% per year from 2012-2014 (MO +24.6%). Over the last year, MO has returned 27% compared to PM’s loss of 1%. As you can see below, the market’s total shareholder return (“TSR”) has really outpaced PM’s stock since 2011, designated by the downward sloping line.
For two seemingly similar businesses, why has this happened and might it have created a buying opportunity for PM?
Some of you are probably thinking about the currency headwinds impacting PM’s reported results given its international operations, but you might be overlooking a more serious issue – government regulations and excise taxes.
In the US, most of the pain from increased government taxes was felt in 2009 (MO paid twice as much in excise taxes in 2009 compared to 2008). Since then, the environment has been much more stable compared to the rest of the world. The US market is also highly consolidated with the top two players controlling over 80% of the market (MO with 50% share, Reynolds American / Lorillard with 30%+ share). While the number of smokers in the US has dropped from 52 million in 1980 to about 38 million today, industry volumes are holding up better than expected more recently and incremental demand appears to be very price inelastic.
The situation in other parts of the world where PM plays is quite different. The European Union (31% of operating income; 21% of volume), Russia (close to 10% of income and volume), and the Philippines (8% of volume) are three of PM’s top four markets. Unfortunately, the governments of these countries have increasingly taxed tobacco in recent years, eating away profits from PM’s shareholders and denting demand in certain cases.
Starting with the European Union, which accounted for nearly half of PM’s income in 2008, anti-smoking legislation was implemented in mid-2014 with a goal of reducing the number of smokers by 2.4 million (reduce tobacco consumption by 2% over the next five years). The rules placed further restrictions on how tobacco products can be manufactured, presented and sold. As seen below, packs will now require picture and text health warnings covering 65% of the front and the back of cigarette packs and at least 50% of the sides of packs.
In 2013, the Philippines hiked excise taxes enough to raise the average price per cigarette pack by 48%. From 2009 to 2013, the number of smokers dropped from 28.3% of adults to 25.4% while government revenue from tobacco more than doubled. In 2014, the government’s income from tobacco taxes jumped another 50% compared to 2013 and it expects to collect about 20% more revenue from sin products in 2015. There is really no end in sight as Commissioner Kim Jacinto-Henares has stated that the price of cigarettes remains relatively cheap compared with some neighboring nations and that cigarette consumption has remained fairly steady despite the tax increases. Annual excise tax increases are slated through 2017. The government is benefiting from the tobacco market’s inelasticity, not PM.
The outlook in Russia, which consumes the second most cigarettes per person in the world, is even worse. In June 2013, a new law went into effect that banned smoking in many public places, banned advertising of tobacco products, and required graphic warning labels to be placed on cigarette packs. Russia implemented a second, tougher phase of legislation in mid-2014, banning smoking in all restaurants, cafes, hotels, and trains. Sales at kiosks and street stalls are also prohibited. Excise taxes have more than tripled the average cost of a packet of cigarettes in Russia since 2006 and show no signs of slowing down, further pressuring volume trends. Through July 2015, industry volumes were down over 6% and expected to end the year down about 10% compared to 2014.
What does this all mean? The following tables show the big differences in tax levels and trends between MO and PM.
From 2012 through 2014, PM’s excise taxes as a percentage of total sales increased from 59.5% to 62.8%, reducing its gross margins by 300 basis points and causing gross profit to contract nearly 10% despite growing its sales from $77.4 billion to $80.1 billion. The European Union has one of the highest excise tax rates on tobacco in the world, eating up about 70% of the revenue PM derives from the region.
Alternatively, MO’s excise taxes decreased over 200 basis points as a percentage of sales from 2012 to 2014, falling from 28.9% to 26.8%. This proportion of taxes is less than half of what PM has to pay for every dollar of sales (63% for PM versus 27% for MO)! As a result, MO’s gross profit has grown by 6% over the last three years and margins rose from 38.8% to 41.4% despite flat sales.
The company’s differences in leverage have also contributed to PM’s disappointing performance in recent years. PM stretched its balance sheet in recent years, increasing total debt from $18.5 billion in 2011 to a whopping $29.5 billion in 2014. Interest expense rose more than 25% from $800 million to over $1 billion, eating into net income. Altogether, PM has seen net income drop by 15% since 2012 despite total sales growth of 3.5% (i.e. more people are smoking or willing to pay more to smoke despite government rules, but even more of PM’s sales are headed to the government and bondholders instead of its shareholders).
MO’s more favorable excise tax situation and conservative balance sheet has allowed it to enjoy net income growth of more than 20% since 2012 despite flat sales. As seen below, MO’s total debt inched up from $13.7 billion in 2011 to $14.7 billion in 2014, allowing the company to actually reduce interest expense by nearly 30% over the last three years as it took advantage of lower interest rates.
Is all hope lost for PM? Can it start generating net income growth again? Should investors sell and run for the hills?
At the end of the day, the tobacco industry is still an attractive area for investment for income-seeking dividend investors because of its stable cash flow, inelastic demand characteristics, and relatively slow pace of change. While many international markets have demonstrated far greater volatility in recent years due to new legislation, currency movements, and more, there is still much to like about PM’s long-term prospects.
From a pure volume growth perspective, international markets are still the place to be. Between 1980 and 2012, the number of adults who smoke increased from 721 million to nearly 1 billion, according to a study in the Journal of the American Medical Association. The number of cigarettes smoked globally jumped from about 5 trillion to 6.25 trillion despite the global smoking rate falling from 26% to 18.7% during the study period.
China has driven most of this growth and now has over 300 million smokers, about one third of all the smokers in the world. In fact, the Chinese market now consumes more cigarettes than all other low- and middle-income countries combined. PM has very little presence in China today but is actively growing its presence in this powerhouse market. If successful, continued diversification out of the tax-heavy European Union should gradually lift or at least stabilize gross margins.
While some of PM’s top markets by volume are hurting, its second largest market, Indonesia, continues seeing low-single digit volume growth. The company’s diversification across 180 different countries helps reduce single-country risk, and its wide range of premium mid-price, and low-price brands provides further balance. Additionally, there has been an ongoing trend of tobacco companies consolidating their brand portfolios, reducing focus on local brands in favor of international brands. PM is well positioned to benefit from this development because international brands, including the iconic Marlboro brand, accounted for more than 70% of its shipment volume in 2014.
Outside of traditional cigarettes, PM is spending half of its R&D budget on potentially less harmful e-cigarettes and Reduced Risk Products (iQOS, HeatSticks, e-vapor, and more). The company believes these products could add incremental margins of $720 million to $1.2 billion per year once incremental volume of 30 to 50 billion units is achieved. With total gross profit of just under $20 billion last year, commercialization success would provide some stability to the business but doesn’t seem likely to be a massive game changer – more like insurance to mitigate the mounting losses of smoking quitters.
For now, PM’s underlying business appears to be in a decent state. YTD cigarette volumes are down about 1%, in line with PM’s expectations for a full year organic volume decline of 1% to 1.5%. The company’s international market share, excluding China and the US, is also up 0.3% to 28.6% in 2015. Moderate volume declines, coupled with continued cost and productivity savings and gradual expansion into larger markets and less harmful categories, should continue to allow PM’s business to at least tread water, if not continue growing, while it works through excise tax challenges and higher interest expenses.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
PM scored a Safety Score of 76, a ranking that suggests PM’s dividend is safer than 76% of all other dividend stocks. Given the stable nature of the tobacco industry, PM’s high score isn’t a surprise.
Over the trailing twelve months, PM’s dividend has consumed 84% of its unadjusted GAAP earnings and 95% of its free cash flow. Payout ratios in excess of 75% should start flashing warning lights, especially if the business is cyclical and has significant debt. While PM has meaningful leverage, its cash flows are very stable and reduce the risk associated with such elevated payout ratios.
Looking at longer-term trends in payout ratios can be even more helpful. Our dividend tools let you view a stock’s EPS and free cash flow payout ratios over the last decade. As seen below, PM’s payout ratios have remained pretty stable, generally between 60% and 80%.
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. Our Stock Analyzer tool lets us see how a company performed during the financial crisis in one click. PM’s reported sales were down just 2% in fiscal year 2009, and free cash flow per share actually increased – tobacco is a very durable business.
High quality companies are able to generate cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio. Tobacco companies are some of the most consistent cash generators you can find, and PM is no exception:
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.
As seen below, PM’s long-term debt to capital ratio has steadily increased over the last eight years, reaching 1.71 in 2014. These figures are a bit skewed from the separation costs PM incurred in FY 08, which cut its reported shareholders’ equity in half. Regardless, for most companies, we prefer to see a debt to capital ratio below 0.5. PM’s business is non-cyclical and generates predictable cash flows to maintain a more geared balance sheet, but we would prefer to see debt levels reduced a bit.
The credit metrics below underscore PM’s heavy debt load. The company only has $1.8 billion in cash on hand compared to total book debt obligations of $29.2 billion. Interest payments over the last twelve months have also exceeded $1 billion. As previously mentioned, PM’s impressive cash generation alleviates some of these concerns – the company generated over $6.5 billion in free cash flow last year and could cover its entire net debt with 2.4 years of EBIT.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
PM’s Growth Score is 50, meaning its dividend’s growth potential ranks exactly in line with the average dividend stock’s growth potential. The company’s high payout ratios and levered balance sheet work against it, but the stickiness of the tobacco industry and its consistent cash flow generation provide support for future growth.
PM has increased its dividend each year since spinning off in 2008 and most recently raised its dividend by 6% to $1.00 per share. Its next dividend announcement is right around the corner and will likely be in the 5-6% range again. The company’s dividend has increased at an 11% annual rate over the last 3- and 5-year periods. Until its key markets stabilize, currency headwinds moderate, and the balance sheet shows some improvement, double-digit dividend growth seems unlikely going forward.
PM’s dividend yield is 5.0%, a Yield Score of 79 in our database – this means that PM’s current dividend yield is higher than 79% of other dividend stocks in the market. Given the nice safety and reasonable growth characteristics of PM’s dividend, today’s yield appears to be appealing, especially for income-focused investors.
PM also trades at a little under 17x last year’s earnings and at 18x forward earnings estimates. While not a bargain, the valuation appears to be reasonable for a company of PM’s quality. If the market volatility continues, PM can add some stability and reliable current income to a portfolio.
At first glance, PM’s business might appear significantly more attractive than MO’s because of its international growth opportunities. While currency headwinds are hurting results, unfavorable tobacco legislation in some of PM’s largest markets and the company’s higher interest expenses have been the much larger contributors to the stock’s disappointing performance since 2012. While these issues could continue to challenge near-term earnings growth, opportunities exist for PM to grow its profits longer-term – expansion into China, continued cost-cutting, growth of reduced-risk products, share gains for international brands over local brands, and rising disposable incomes in emerging markets. For income-focused dividend investors, PM’s 5% dividend yield looks appealing.
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