This article first appeared on Dividends & Income

Investors tend to refer to certain stocks as “sin stocks”.

Think companies associated with activities or industries that could be considered unethical.

Gambling, weapons manufacturing, tobacco, etc.

Sin stocks often have high yields, due to a more narrow investor base.

And I can tell you from experience, “sin dividends” spend all the same as any other.

I love dividends.

I live off of dividends.

In fact, I went from below broke at age 27 to financially free at age 33, as I lay out in my Early Retirement Blueprint.

My real-money, six-figure FIRE Fund generates enough five-figure passive dividend income to cover my bills.

I built that portfolio by following the tenets of dividend growth investing.

This is a strategy that advocates buying and holding shares in high-quality businesses that pay shareholders reliable and rising cash dividends.

The Dividend Champions, Contenders, and Challengers list contains invaluable data on more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years.

Dividend growth investing is so powerful largely because you’re limiting yourself to only those businesses that can afford rising dividend payments.

It’s the ultimate “show me the money” strategy. 

Jason Fieber's Dividend Growth PortfolioBut as great as it is, dividend growth investors must do their homework before buying stocks.

That includes fundamental analysis and valuation.

Valuation can be particularly critical, and it can play a major role in the outcome of an investment.

Price determines what you pay. Value determines what you get.

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

This is relative to what the same stock might otherwise provide 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.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value. It’s protection against the possible downside.

Buying “sin stocks” with high yields and growing dividends, and doing so when they’re undervalued, can add a lot of prospective income and total return to your portfolio.

The valuation homework isn’t that difficult for investors these days.

Fellow contributor Dave Van Knapp has made that even easier, via the introduction of Lesson 11: Valuation.

Part of a larger series of “lessons” on dividend growth investing, Lesson 11 provides a valuation template that you can apply to almost 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.

With corporate roots dating back to 1847, Philip Morris International is now a $123 billion (by market cap) global giant.

FY 2019 revenue can be broken down geographically as follows: European Union, 34%; South & Southeast Asia, 20%; Middle East & Africa, 15%; East Asia & Australia, 11%; Eastern Europe, 10%; and Latin America & Canada, 10%.

The company’s global market share is an estimated 28%, excluding China and the US.

Their huge market share is predicated largely on the strength and ubiquity of their Marlboro brand, the #1 cigarette brand in the world.

The Marlboro brand alone contributed over 35% of total cigarette sales volume for last year.

This is one of the kings of “sin stocks”.

The core business model – tobacco – is one of the most lucrative out there, commanding huge margins off of products that are addictive by nature.

That nature has historically helped the business in times of trouble, such as the current pandemic crisis we’re dealing with – people are typically more likely to smoke during times of economic stress.

However, this is also one of the most taxed and regulated business models out there. That makes it less appealing and rewarding for investors than it’d otherwise be.

Then there’s the fact that some people consider the business model unethical.

This keeps the investor base somewhat narrow, which also tends to keep the valuation low.

And that low valuation can lead to a high yield, as well as the opportunity to reinvest one big dividend after another into an unloved stock.

Dividend Growth, Growth Rate, Payout Ratio and Yield

The stock yields a mouth-watering 5.85% right now.

That’s about three times higher than the broader market’s yield.

It’s also more than 70 basis points higher than the stock’s own five-year average yield.

This giant yield comes on top of a respectable five-year dividend growth rate of 3.4%, with Philip Morris International increasing its dividend for 12 consecutive years.

That dividend growth streak is as long as it could possibly be, as the company was spun-off by former parent company Altria Group Inc. (MO) in 2008.

Philip Morris International has been paying a growing dividend since it became an independent company.

And while the payout ratio, at 100%, looks unsustainable, one of the more important accounting aspects to remember here is that the company reports earnings in US dollar terms. While it’s based in the United States, it earns profit everywhere else.

Thus, currency exchange rates can cause the business to suffer large swings in GAAP earnings.

Free cash flow does more comfortably cover the dividend than GAAP earnings, although I will say that the overall dividend coverage is tight and will limit the size of dividend raises over the next few years or so.

Revenue and Earnings Growth

And it’s ultimately those future dividend increases today’s investors care about.

We risk and invest today’s dollars for tomorrow’s rewards.

Future growth also tells us a lot about what the stock might be intrinsically worth.

As such, I’ll now build out a future growth trajectory for Philip Morris International.

I’ll first rely on what the company has done over the last decade in terms of top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication of profit growth.

Combining the proven past with a future forecast in this manner should allow us to extrapolate out some reasonable growth assumptions.

The company increased its revenue from $27.208 billion in FY 2010 to $29.805 billion in FY 2019, which is a compound annual growth rate of 1.02%.

That’s slightly disappointing.

However, we have to keep in mind that tobacco usage globally is in a secular decline.

This means volumes are regularly dropping.

Fortunately, due to demand being price inelastic, the company can slowly increase the price on its products to offset volume reduction.

In addition, because the business is a cash cow with little need for ongoing reinvestment, the company can buy back stock and drive excess bottom-line growth.

For perspective, the company reduced its outstanding share count by approximately 15% over the last 10 years.

Earnings per share expanded from $3.92 to $4.61 over this period, which is a CAGR of 1.82%.

Again, not super impressive.

But I think the USD reporting does throw things off somewhat.

If we look at free cash flow on a per-share basis, that compounded at a rate closer to 2.5% over the last decade.

And I think that’s pretty close to the company’s true growth profile.

Looking forward, CFRA believes that Philip Morris International will compound its EPS at an annual rate of 3% over the next three years.

This would be right in line with what I just noted about FCF/share growth.

Philip Morris International’s future largely hinges on the success of its new IQOS product, which is a unique heat-not-burn device designed to mimic traditional cigarettes while also reducing risk.

IQOS is being rolled out globally. And it received FDA approval for sale in the US in April 2019. Former parent Altria Group Inc. has the exclusive licensing agreement to market and sell this product in the United States.

This product is a growth avenue in a business that’s facing secular decline in its traditional offerings.

To give you context, cigarette shipment volume was down by 4.5% for FY 2019. However, heated tobacco unit shipment volume was up by a whopping 44.2% for the same year (to 59.7 billion units).

I think CFRA has an accurate call on near-term EPS growth, which will likely translate to similar dividend growth (albeit slightly lower, due to the high payout ratio).

Financial Position

Moving over to the balance sheet, the company has a relatively solid financial position.

While the long-term debt/equity ratio is N/A because of negative common equity, an interest coverage ratio of over 13 indicates no issues whatsoever with leverage.

Profitability, as you might expect, is quite robust.

After all, they specialize in a high-margin, addictive product.

Over the last five years, the firm has averaged annual net margin of 24.65%. ROE is N/A due to negative equity.

This is a low-growth, cash-cow business that’s perfect for income investors who like their dividends about as big as they come.

And with scale, strong brand recognition, and extremely high barriers to entry, competitive advantages protect the business and that dividend.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

I will say that litigation is the largest of the three, in my view.

Regulation actually works to the company’s advantage in some ways. That’s because there are strong restrictions on the industry, particularly as it relates to advertising. This creates barriers to entry, limiting competition. It also reduces the need to spend on advertising. An entrenched oligopoly has the ability to engage in rational pricing.

However, plain packaging is an example of regulation that works against the business model.

And litigation is a constant sore spot in this industry.

The dollar is a risk here because of the aforementioned accounting idiosyncrasy.

Lastly, any acceleration in traditional cigarette volume declines, especially if paired with less adoption of the IQOS, would hurt profitability.

With these risks known, I still think this is a compelling long-term investment idea.

That’s particularly so with the valuation being so attractive…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 17.14.

This is far less than the broader market’s earnings multiple.

It’s also well off of the stock’s own five-year average P/E ratio of 20.6.

We can also see that the current P/CF ratio of 14.7 is disconnected from its three-year average of 16.2.

And the yield, as noted earlier, is materially higher than its own recent historical average.

So the stock does look cheap based on basic valuation metrics. 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 (to account for the high yield) and a long-term dividend growth rate of 3%.

This DGR is right in line with the long-term FCF/share growth rate. It also matches CFRA’s near-term EPS growth rate. And it’s lower than the company’s own five-year dividend growth rate.

It’s likely that dividend growth over the next year or two will be muted.

But their new IQOS has an incredible growth runway in front of it, and the company’s need for investment is also coming down.

Thus, I think the long-term dividend growth rate will average out nicely.

The DDM analysis gives me a fair value of $96.41.

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.

This stock looks cheap, even after using a valuation model that was arguably conservative.

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 $98.00.

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 5-star “STRONG BUY”, with a 12-month target price of $95.00.

We have a tight consensus. Averaging the three numbers out gives us a final valuation of $96.47, which would indicate the stock is possibly 21% undervalued.

Bottom line: Philip Morris International Inc. (PM) is a rare stock commanding a 5-star rating from both Morningstar and CFRA. With an exciting growth product rolling out globally, a near-6% yield, a clear commitment to the dividend, and the potential that shares are 21% undervalued, dividend growth investors okay with a “sin stock” should take a serious look at this one.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

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 an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends and Income