With the S&P 500 at record highs, it’s important to keep an old adage in mind.
The stock market is a market of stocks.
The S&P 500 isn’t one monolithic structure.
It’s made up of ~500 individual stocks.
Every stock represents a sliver of ownership in a real business.
Each stock features its own set of fundamentals, risks, and valuation.
And they must be assessed at an individual level.
Even while the S&P 500 is at incredible levels, numerous stocks are way off of their recent highs.
Looking for compelling long-term investment opportunities is something I take pride and pleasure in.
And it’s been very rewarding.
I went from below broke at 27 years old to financially free and retired at 33.
I describe exactly what I did and how I did it in my Early Retirement Blueprint.
Making intelligent investment decisions is critical to one’s long-term financial success.
And I’d argue that dividend growth investing makes it hard make unwise investment choices.
That’s because high-quality dividend growth stocks tend to be excellent long-term investments by their very nature.
Just take a look at the Dividend Champions, Contenders, and Challengers list.
It’s chock-full of world-class enterprises.
After all, it takes a special kind of business to be able to hand out rising dividends for years on end.
By living below my means and investing in high-quality dividend growth stocks, I was able to build the FIRE Fund.
It generates the five-figure dividend income I live off of.
Now, I’ve never blindly or randomly bought dividend growth stocks.
And neither should you.
Each stock, which represents a real business, needs to be individually analyzed.
Of particular importance is valuation, which also varies by the stock.
Valuation will play a major role in the long-term performance of any investment.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated.
A lower price, all else equal, will result in a higher yield.
That higher yield leads to greater long-term total return potential.
Total return is the sum of investment income and capital gain. A higher yield leads to more of the former.
Plus, possible capital gain is given a boost via the “upside” available between a lower price and higher intrinsic value.
These dynamics should reduce risk.
That occurs through the margin of safety introduced with undervaluation.
This “buffer” protects the investor against ending up upside down on an investment.
Any number of unforeseen issues can crop up and deteriorate the value of a business: mismanagement, new regulation, etc.
Investors should always protect themselves against this by buying when there is an acceptable margin of safety.
Undervaluation is advantageous.
Fortunately, it’s not impossible to take advantage of.
Fellow contributor Dave Van Knapp has made that easier than ever before through his valuation template.
Lesson 11: Valuation, part of an overarching series on dividend growth investing, provides you with the information you need to confidently value just about any dividend growth stock out there.
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 2018 sales break down geographically: Asia, 35%; European Union, 31%; Middle East & Africa, 14%; Eastern Europe, 10%; and Latin America and Canada, 10%.
Philip Morris International dominates the worldwide tobacco market. The company commands an estimated 28% global market share. That excludes China and the US.
This huge share of the market is largely due to the strength of their Marlboro brand, which is the #1 cigarette brand in the world.
This one brand made up over 35% of the company’s total cigarette volume last year.
The elephant in the room as it pertains to the investment thesis here is the ongoing viability of cigarettes as a business model.
But there are two important points to keep in mind.
First, there’s no sudden demise here.
The company sold just over 740 billion cigarettes last fiscal year, which was down 2.8% over the prior year.
Second, the invention of e-cigarettes has been just the innovation this industry needs.
For perspective, the company’s heated tobacco shipments increased by 14.2% last fiscal year, to 41.4 billion units.
Philip Morris International has been investing heavily in the future of reduced-risk products (RRPs).
Their flagship IQOS (I quit ordinary smoking) system is a major result of that.
This is heat-not-burn technology that is designed to reduce the the levels of harmful chemicals ingested from traditional cigarettes, all while still producing the same smoking experience.
IQOS has been wildly popular overseas thus far.
And the FDA just recently approved the sale of their IQOS heated tobacco system in the US. Altria Group Inc. (MO) has the exclusive licensing agreement to market and sell this product in the United States.
This product has a unique and exciting spot in the marketplace, bridging a gap between traditional cigarettes and e-cigarettes.
Now, one can argue all day long about whether or not someone should smoke (or drink alcohol, or eat fatty foods, etc.). I’m personally grateful for personal freedoms.
What’s much more difficult to argue about is the long-term effectiveness of tobacco companies as investments.
Before being spun off from Altria Group in 2008, the results of the combined company over many decades are something to behold.
Philip Morris International has admittedly stumbled a bit here and there since going independent.
A strong dollar hasn’t helped them. That’s because they earn in foreign currencies and then translate the profits into dollars as a US-based multinational that doesn’t actually directly sell products in the US.
But they’re still a free cash flow machine.
That cash flow is, perhaps ironically, protected by strict regulations.
Competition is stifled because it’s almost impossible for new entrants to enter the marketplace.
You thus end up with rational pricing among an oligopoly.
And restrictive advertising limits SG&A costs, bolstering margins.
An FCF machine like this means large and growing dividends.
Indeed, the company has increased its dividend every year since the spin-off.
That’s 11 consecutive years.
While the five-year dividend growth rate of 4.8% isn’t much to write home about, the stock yields a monstrous 5.89%.
That yield is three times higher than the broader market!
It’s also ~100 basis points higher than the stock’s own five-year average yield. This speaks on what I noted above about valuation and yield.
When the yield is that high, you don’t need big growth numbers to make the investment case compelling.
One glaring blemish here is the payout ratio.
At 92.1%, it’s high. Even for a tobacco company that actually targets a high payout ratio.
But if there’s any business model out there that can sustain something like this for a short period of time, it would be this one.
Of course, we invest in where a company is going, not where it’s been.
Future dividend growth expectations will give us a guide as it relates to what kind of income this stock might pump out over the long run.
It also gives us the information we need to ascertain an estimate of intrinsic value.
Building out that future expectation does rely on long-term performance, however.
I’ll first show you the company’s top-line and bottom-line growth rates over the last 10 years.
And then I’ll compare that to a near-term professional expectation for profit growth.
This allows us to develop a mental trajectory for where the company is going.
Philip Morris International increased its revenue from $25.035 billion in FY 2009 to $29.625 billion in FY 2018.
That’s a compound annual growth rate of 1.89%.
Meanwhile, earnings per share expanded from $3.24 to $5.08 over this period, which is a CAGR of 5.12%.
Sizable buybacks have helped.
The outstanding share count is down by approximately 20% over the last decade.
These are very good, if not not amazing, numbers.
We have to keep perspective here.
It’s a mature company. And its primary product in in secular decline.
The fact that they’re able to squeak out 5%+ annual growth over a pretty challenging period is actually pretty impressive.
Plus, you’re getting that 5%+ yield.
Moving forward, CFRA is forecasting that Philip Morris International will compound its EPS at an annual rate of 5% over the next three years.
Status quo, basically.
Their prediction includes higher pricing and greater demand from heated products offset by volume declines in traditional cigarettes and uncertainty regarding global trading and regulation.
However, the strength of the dollar will have a lot to say about the GAAP numbers.
If the company is able to continue compounding at 5%, I’d consider that a big win.
But I wouldn’t necessarily count on dividend growth hitting that mark.
With an elevated payout ratio, I would actually expect dividend growth to fall short of earnings growth.
I see low-single-digit dividend growth as realistic for the foreseeable future.
Looking at the balance sheet, it’s fairly solid.
There’s no applicable long-term debt/equity ratio because common equity is negative. Treasury stock, relating to the aforementioned buybacks, is substantial.
But total cash is ~25% of long-term debt.
Moreover, the interest coverage ratio is over 13.
That’s a strong number that indicates no issues whatsoever with leverage.
In addition, it’s an improved number relative to a few years ago.
Profitability, as expected, is outstanding.
A cigarette is a high-margin product at its core. But the nature of the industry’s dynamics supercharge this.
Over the last five years, the company has averaged annual net margin of 24.85%. ROE is N/A due to the negative common equity.
That’s an enviable net margin many companies would love to have.
Overall, this is a very attractive business.
Incredible margins, solid balance sheet, extremely high yield, and an addictive product with a captive audience.
It’s a cash flow machine that is tough to match.
But there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The former two, in particular, are heightened in this industry.
Plain packaging, for example, is the kind of regulation that threatens the business by way of brand power destruction.
The dollar is a risk that is somewhat unique to this business because of its structure.
Also, any increase in volume declines would further harm sales and the company’s viability.
But the advantages do seem to greatly outweigh the disadvantages here.
And at the right price, this could be a home run of an investment.
The stock is trading hands for a P/E ratio of 15.64.
That’s well below the broader market’s earnings multiple.
It’s also markedly lower than the stock’s own five-year average P/E ratio of 20.5.
The cash flow multiple is only 12.9 here.
Compare that to the three-year average P/CF ratio of 18.0.
And the yield, as shown earlier, is substantially higher than its recent historical average.
The stock looks fairly cheap. But how cheap might it be? What would a reasonable 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 well off of both the long-term dividend growth and EPS growth thus far.
Furthermore, the forecast for near-term EPS growth is well above this mark.
But I think the lower DGR rate moving forward is justified considering the high payout ratio.
I often err on the side of caution. It’s especially warranted in this case.
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.
Even with what I’d argue is a conservative valuation, the stock still looks 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 $82.00.
I came out right in line with Morningstar. Averaging the three numbers out gives us a final valuation of $96.29. That would indicate the stock is possibly 24% undervalued.
Bottom line: Philip Morris International Inc. (PM) is a high-margin business with great fundamentals and an exciting new growth product in its lineup. With a yield near 6%, 11 consecutive annual dividend raises since its inception, and the potential that shares are 24% undervalued, this is the kind of high-yield dividend growth stock that income seekers should take a very close look at.
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 64. 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 a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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