Undervalued Dividend Growth Stock of the Week: Philip Morris International (PM)

People like to make things more difficult than they need to be.

Perhaps it’s human nature.

One thing that people overcomplicate for sure is the process of building wealth and getting rich.

Getting rich is actually a simple process.

It requires only a very short list of ingredients.

One needs to just save their money and invest that capital intelligently over the long run. 

Now, I said simple. I didn’t say easy.

If it were easy, everyone would be rich.

But anything worth having is worth working hard and waiting for.

Well, building wealth the right way is something that does require some hard work and patience.

I speak from experience.

I went from below broke at 27 years old to financially free. 

How that happened exactly is something I reveal in my Early Retirement Blueprint.

It took me six years to build wealth and make my dreams come true. This while a lot of people out there can barely stay focused on something for more than 30 seconds.

Compounding takes time to get moving. Once it’s rolling, though, it’s an unstoppable machine.

My personal compounding machine is my FIRE Fund, which is my real-life and real-money dividend growth stock portfolio.

It generates the five-figure passive dividend income I need to be financially free.

Best of all, that dividend income is growing, aggressively, year in and year out.

Jason Fieber's Dividend Growth PortfolioThat’s because I invest in high-quality dividend growth stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.

Passive income is great. But that income needs to grow, too. Inflation ensures higher prices on goods and services in the future.

Passive income must keep pace. Otherwise, you fall behind.

Dividend growth investing solves this quandary. Actually, it more than solves it.

That’s because the strategy involves buying equity shares in companies that are paying rising cash dividend payments.

Not only that, but these dividends are often growing faster than inflation. That means shareholders are seeing their purchasing power increase year after year.

That’s compounding.

But you need to take advantage of compounding correctly and buy high-quality dividend growth stocks when they’re undervalued.

Do it routinely. Wait. Get rich.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk. 

That’s all relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

Total return is capital gain and investment income.

The higher yield will boost the latter, resulting in greater long-term total return potential.

Capital gain is also given a possible boost, via the “upside” that exists between price and value.

While the stock market isn’t necessarily accurate at pricing stocks in the short term (leading to undervaluation opportunities), price and value do tend to closely correlate over the long run.

A more accurate pricing in line with value would lead to capital gain, which is on top of whatever capital gain would occur as a company becomes worth more over time.

This should reduce risk.

Risking less capital for the same asset is the very definition of reducing risk. It’s laying out less cash.

But undervaluation should also introduce a margin of safety. That’s a “buffer” that protects the investor against unforeseen issues that could reduce the value of a stock/investment.

We can’t predict the future. We always need to approach investing cautiously and pragmatically.

These dynamics are obviously appealing and favorable.

Fortunately, they’re not impossible to spot or take advantage of.

Fellow contributor Dave Van Knapp has made the valuation process much easier by way of Lesson 11: Valuation.

That’s a “lesson” that’s part of an overarching series of articles designed to teach dividend growth investing to investors of all experience levels.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Philip Morris International Inc. (PM)

Philip Morris International Inc. (PM) is the world’s largest publicly traded tobacco company, engaged in the manufacture and marketing of tobacco and related products.

Fiscal year 2017 sales break down geographically as following: Asia, 37.5%; European Union, 28.9%; Eastern Europe,
Middle East & Africa, 23.3%; and Latin America and Canada, 10.2%.

Philip Morris International dominates the worldwide tobacco market, with an estimated 28% market share of the global tobacco market. That excludes China and the US.

This is in no small part due to the strength of their flagship brand Marlboro, which is the #1 cigarette brand worldwide.

High-quality tobacco companies have actually been excellent investments over the long run, which is counterintuitive.

Aggressive anti-tobacco marketing campaigns, ominpresent litigation, and stringent regulations have harmed volumes.

However, we have to remember that a company like Philip Morris International has a captive consumer base.

The addictive nature of their products creates a situation where demand has low elasticity to price: reasonable price increases don’t significantly harm demand.

Moreover, the stringent regulations have also been partially helpful in a counterintuitive way.

Due to severe restrictions on tobacco advertising in many markets, it’s almost impossible for new competition to enter the field. The barriers to entry are very high.

In addition, you have rational pricing and limited competition among the established players.

And restrictive advertising forcefully reduces SG&A costs, further bolstering margins.

Tobacco companies are free cash flow machines.

Since investors have naturally been shy around these companies, and since some funds stay away due to restrictions, valuations on these stocks have stayed compressed for years.

Well, we know what undervaluation means.

We know that it leads to big yields, first off.

The stock offers a monstrous yield of 6.83% right now.

This yield is more than three times higher than the S&P 500. It’s also almost 200 basis points higher than the stock’s own five-year average yield.

That isn’t just a big dividend, though. That’s a big, growing dividend.

Philip Morris International has increased its dividend for 11 consecutive years.

The five-year dividend growth rate stands at 5.8%.

Not huge. But it’s certainly higher than the US inflation rate. And it’s coupled with a yield near 7%!

One drawback, though, is the payout ratio.

It’s currently sitting at 88.7%. (I added back in $0.84 to TTM EPS due to the one-time tax hit in Q4 2017 that isn’t material to long-term earnings power.)

That’s high. The company targets a payout ratio of 80% or so due to its mature status and stable earnings. But we’re sitting higher than even that lofty target.

As such, I wouldn’t expect dividend growth to outpace earnings growth moving forward.

But with a starting yield of almost 7%, investors are looking at a ton of aggregate dividend income over the next 5-10 years anyway. That’s assuming the business doesn’t collapse and cut/eliminate the dividend, which is something that’s highly unlikely.

In order to estimate that future dividend growth, however, we must estimate future earnings growth. The two should closely correlate from here on out.

That business growth estimate will be aided by looking at what the company has done over the long run. So we’ll first look at the company’s track record for top-line and bottom-line growth. And then we’ll compare that to a near-term professional EPS growth forecast.

Blending the known past and estimated future like this should tell us a lot about where the company might be going. And it will greatly help us value the stock.

Philip Morris International has increased its revenue from $25.705 billion in FY 2008 to $28.748 billion in FY 2017. That’s a compound annual growth rate of 1.25%.

Stable. But not huge growth. This shouldn’t be surprising considering all of the aforementioned headwinds.

Meanwhile, EPS grew from $3.31 to $4.48 over this stretch, which is a CAGR of 3.42%.

Again, I added $0.84 back into Q4 2017.

This isn’t inspiring. But a low valuation, high yield, and even modest growth can add up quickly.

It’s important to also note here that Philip Morris International is headquartered in the US, even though it does no business there.

That means the company earns profit from markets all over the world. Then they translate that income from various currencies into US dollars for GAAP reporting. This causes wild fluctuations in GAAP EPS.

Share buybacks have helped. The company has reduced its outstanding share count by approximately 25% over the last 10 years. That’s significant.

The dollar has been strong over a good portion of the prior decade, but a recent weakening could assist Philip Morris International with future earnings reports.

Indeed, it’s where a company is going (not where it’s been) that matters most for investors.

Looking out into the near term, CFRA is predicting that PMI will compound its EPS at an annual rate of 8% over the next three years.

Lower taxes due to tax reform, pricing increases, and market share gains in heated tobacco products are factored into this forecast.

It’s that last point that’s particularly relevant.

The company has spent considerable money and time in recent years investing in reduced-risk products. The advent of e-cigarettes has arguably been a boon for the tobacco industry. E-cigs compete with traditional cigarettes, but it’s finally a path to growth.

PMI’s flagship RRP is iQOS. It’s a heat-not-burn electronic smoking system. And it offers growth in a portfolio that’s plagued by volume drops.

I’ll show you what that looks like with the numbers.

The company saw its traditional cigarette sales drop from 812.9 billion cigarettes in 2016 to 798.2 billion cigarettes in 2017.

Meanwhile, heated tobacco unit shipments in 2017 totaled 36.2 billion in 2017. That compares to 7.4 billion in 2016.

This is no doubt helped by rolling out and inventory filling, but it’s still pretty incredible. The difference between combustibles and heated units is stark.

Building on CFRA’s forecast is PMI’s own guidance for FY 2018. The company is guiding for EPS to come in at between $4.97 and $5.02. This would represent growth between 28% to 29% over FY 2017 GAAP EPS.

The approximate midpoint for guidance is $5.00. That would be 11.6% higher than the $4.48 I used earlier, which factors out the tax hit.

Even the company continuing on with ~4% EPS growth would still allow for similar dividend growth. That would be a lot to like when you look at where the starting yield is.

So there’s room for upside surprise here.

The company’s balance sheet has debt. But I’d actually rate the company’s balance sheet as fairly strong for the industry.

There’s no applicable long-term debt/equity ratio. That’s because of negative equity. There’s a lot of treasury stock on the balance sheet due to the buybacks.

But cash and equivalents are almost 25% of long-term debt.

More importantly, the interest coverage ratio is over 10.

That indicates no apparent issues with covering interest expenses or overall leverage.

Profitability is mighty impressive. This shouldn’t be a surprise due to the favorable economics noted earlier.

Over the last five years, the firm has averaged annual net margin of 24.99%. ROE is n/a due to negative common equity.

Incredible in and of itself, that net margin even includes a FY 2017 that was hamstrung by the tax hit.

A lower tax rate and a more favorable currency exchange rate could serve to increase this even further.

Philip Morris International has some solid numbers across the board.

But they’re positioned to do even better moving forward, which is very exciting.

There are numerous tailwinds setting the business up very well.

And while investors wait for those tailwinds to gust, the stock pays a massive dividend.

Of course, risks should be considered.

As touched on earlier, litigation and regulation are omnipresent and significant. The latter only appears to be getting worse.

An increase in traditional cigarette volume declines would be worrisome.

And competition, while established and rational, is still fierce.

Overall, though, it appears to be a low-risk idea. Especially at this valuation.

The stock has declined ~35% over the last year, dropping the valuation down to a very compelling level…

The P/E ratio is 12.99. That’s using adjusted TTM EPS.

This is considerably below the broader market. It’s also way off of the stock’s own five-year average P/E ratio of 20.5.

The cash flow multiple, at 10.4, is also substantially below its three-year average of 18.0.

And the yield, as shown earlier, is remarkably high. Much higher than its recent historical average.

So the stock does appear to be very cheap. But what would a rational estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of just 3.5%.

That DGR is roughly in line with the 10-year EPS growth rate.

I’m using that as my baseline because the payout ratio is so high.

But an acceleration of EPS growth could make this a very conservative assumption.

That’s against the backdrop of the most recent dividend increase that came in at over 6.5%.

However, I like to err on the side of caution.

The DDM analysis gives me a fair value of $104.88.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

I believe my valuation was incredibly cautious. Yet the stock still looks extremely cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates PM as a 5-star stock, with a fair value estimate of $102.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates PM as a 3-star “HOLD”, with a 12-month target price of $92.00.

I came out slightly high. But we all agree that the stock is worth a lot more than its current price. Averaging out the three numbers gives us a final valuation of $99.63. That would indicate the stock is potentially 49% undervalued.

Bottom line: Philip Morris International (PM) is a dominant firm with the world’s most popular brand in its industry. Numerous competitive advantages, accelerating growth, incredible margins, a yield near 7%, and the possibility that shares are 49% undervalued means this could be one of the most smokin’ deals in the entire market.

-Jason Fieber

Note from DTA: How safe is PM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 68. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, PM’s dividend appears safe with an very unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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