When I first started covering stocks, there were two things I quickly became aware of: (1) the tobacco industry in general had been the best performing sector of the economy for American investors by far, with the old Philip Morris getting singled out specifically in Jeremy Siegel’s research as the best investment during the second part of the 20th century, and (2) Philip Morris International is really the only tobacco company in the world that has a shot of faring better than the 3.5% tobacco shipping declines that have occurred in the United States from 1982 through 2013 and I use as the benchmark expectation for smoking declines as countries Westernize.
I covered the unique prospects for Philip Morris International on two previous occasions, most recently in January 2014 “Philip Morris International Is The Best Long-Term Tobacco Investment” and January 2015 “Philip Morris International Stock And The United States Dollar.” The point of both articles was to note that Philip Morris International was an attractively priced stock in the $70s and low $80s as the strength of the U.S. dollar was obscuring satisfactory business performance and providing investors with P/E ratio information that masked superior earnings power.
Since both of those instances, the gap between the moderate discount of Philip Morris’s valuation and the range of fair value has closed. This year, Philip Morris is expected to earn around $4.40-$4.50, which is effectively $5 per share if you regard Philip Morris’s earnings on a constant-currency basis. With the stock now hovering around $100 per share, you’re paying at least 20x earnings. Even interpreting all the data in favor of trying to regard Philip Morris International as cheap, that is no bargain.
Furthermore, Philip Morris International has used up its balance sheet and dividend payout ratio flexibility over the past eight years. During its first few years after the spinoff, the international tobacco giant was returning about 60% of cash profits to shareholders and had a lightly leveraged balance sheet that was only about 1.5x cash flows.
We’ll use 2011 as an example to show the point–Philip Morris was paying out $2.82 in dividends against $4.85 in profits, or $4.7 billion in dividends against $8.5 billion in net profits. The debt level was sitting at the $14 billion level.
As the business itself saw sales growth slow down in the next two years, followed up by a decline in the U.S. dollar that masked moderate growth thereafter, Philip Morris began borrowing billions of dollars to repurchase stock and increase the earnings per share without the company itself actually growing profits.
The share count has decreased from 1.7 billion to 1.5 billion over the past four years, and that has covered up a bit of the effects of the net profit decline from $8.5 billion to $6.9 billion over that same time (though the $6.9 billion figure is more analogous to $7.7 billion if you measure earnings power on a constant currency basis).
And while, over the long term, the effects of currency swings are usually something of a wash, there are still short-term effects. It is the reported profits, rather than constant currency adjustments, that refers to the cash coming into headquarters that can be redeployed as buybacks, dividends, and general surplus that can be put to later use.
In this regard, Philip Morris is in a bit of a bind. There is a reason the last quarterly dividend hike was only 2%, from $1 to $1.02. It only has $4.45 per share coming in that can possibly be used as dividends. The current $4.08 rate consumes 91.6% of overall profits, and another dividend hike this year will mean that virtually all of the current profits are being returned to shareholders.
If Philip Morris brings in $6.9 billion in profits this year, it is already on pace to pay at least $6.3 billion of it out to shareholders as dividends. The actual figure will only be somewhat above that. It has suspended repurchasing stock, as the shareholders are receiving nearly all of the company’s profits as dividends. The 2015-2016 period will likely be the first year in which Philip Morris sees its share count rise, as those ever-present stock options for executives ought to increase the share count a bit above 1.55 billion (from 2008 through 2014, each share of PM saw its share of profits climb by 23% from the buyback alone).
Meanwhile, the debt taken on from past repurchases weighs on the shareholders of today. While Philip Morris earns $6.9 billion, it now has $27.6 billion in outstanding. Back in 2011, Philip Morris was carrying 1.5x its annual profit in cumulative debt; it now carries 4x its annual profit as cumulative debt. There hasn’t been a whole lot to show for it–earnings are $0.40 per share lower now than they were then–but of course the earnings would be a bit lower if it didn’t repurchase those 200 million shares.
Is it a hold if you already own shares? Sure. It’s still earning obscene 45% returns on total capital. Volumes have been somewhat steady, and the IQOS smokeless cigarettes are off to a very strong early start in Japan. You still get 4% in immediate dividends, and you ought to get high single digit earnings growth over the medium term. That’s not bad.
But given the very high payout ratio and higher than usual debt burden that might drag future returns and dividend increases, and given the 20x earnings valuation, I wouldn’t make it my target it right now.
I’d much prefer to take a point less in current dividend yield and look at beer manufacturer and distiller Diageo. There, you get a 3% dividend yield, and the dividend itself is only half of earnings. The valuation is around 17x or 18x earnings, and much less regulatory impairments in the coming years. Because the cash flows from beer companies is so reliable, it’s hard to get one at a fair price. Diageo’s sale of wine assets have made it less crystal clear to figure out core earnings power, but my estimate is somewhere around $4 billion which assumes the rest of the business growing at a 6% rate.
Over the next ten to fifteen years, I have no hard conclusions about whether Philip Morris International or Diageo will outperform. The managerial competence of tobacco executives, perhaps out of necessity, has been outstanding for shareholders throughout the Philip Morris history. The fast-growing sales of smokeless tobacco internationally has proven to be a strong offset to cigarette volume concerns, and despite the absence of overall profit growth, the volume trends at Philip Morris International have held up still.
Still, it will likely take a few years for the payout ratio and debt burden to come down, and the current price doesn’t really give you a discount for being patient and waiting. At Diageo, it takes fewer things to go right for the investment to pay off both over the medium term and the long term, and the downside risk is not nearly as bad. A preference for Diageo over Philip Morris International is what I mean when I talk about risk-adjusted returns instead of absolute returns (on the former, Diageo is superior, on the latter, I am agnostic).