Looks like I have a little capital from my recent ARCP sale to deploy, so I wanted to take this opportunity to research a potential investment for the excess capital. For me, it was a no-brainer figuring out which stock I was going to analyze. Tobacco has a relatively low weight in my portfolio even though the power companies in the industry offer a very attractive yields. With stock prices falling lately, it seemed like a great time to assess my only tobacco holding, Philip Morris (“PM”), to determine if I should re-up my position.
Who is Philip Morris?
PM is an international cigarette company, with the three largest revenue regions consisting of Europe, Asia and Middle East/Africa. PM’s brand portfolio consists of some pretty big names in the industry, holding brands such as Marlboro, Parliament, L&M, and of course, Philip Morris. In 2008, PM was spun-off from Altria Group (MO), which decided to separate its international and domestic business operations. Now, PM sports the largest market cap in the cigarette industry, sporting a market cap of over 128.1M. The next closest companies are MO, ~$108b, and BTI, ~$104.1b.
Share Repurchase Program
Even though we focus on dividends in this blog, another great way for a company to provide shareholder value is to repurchase some of their current outstanding stock. As we discussed at length in a post a few months ago, a company can use share buyback programs as a means to reduce their share count, increase their EPS, and lower their payout ratio. Thus, buyback programs can provide room for companies to continue to grow their dividend for years to come. For PM, in 2012, the company announced a share repurchase program committing $18b to repurchase shares over three years. Through the 4th Quarter of 2014, PM has spent $12.6 billion to repurchase shares based on their recent earnings release, meaning the company still has $5.4b worth of shares to repurchase under the program. However, during their most recent earnings release, management stated that due to market pressures, the company will not repurchase any additional shares during 2015. This is unfortunate, especially considering how beneficial stock repurchase programs can be for dividend investors, because $5.4b in shares to repurchase this year, which could potentially repurchase ~65.5m shares, increasing EPS from $4.76 to ~$5.19, and lowering the payout ratio to 77%. If the pressures turn out to be short-term in nature and the market conditions improve, management can always decide to repurchase shares under their current program (which they emphasized in the release). Hopefully that is the case and us shareholders will get a boost later on in the year.
Dividend Diplomats’ Stock Screener
- P/E Ratio– Our first test is to assess whether the PE Ratios are less than the S&P 500 ratios. For our analysis, we will use the forward PE ratios, which are based on an average estimated earnings for the year. Currently, the S&P 500’s forward PE ratios is ~17. Based on the table below, BTI is the only one of the three companies to have a forward PE less than the S&P. This is very interesting as I was expecting PM to have the lowest of the group.
- Payout Ratio– As a part of our analysis, we typically focus on companies with payout ratios less than 60% as we believe 60% provides a solid safety net in the event the company’s short-term earnings are impaired. This is a rough number as we have been known to purchase a stock with a payout over 60% before; however, it takes a whole lot of convincing in that scenario and the company better be strong in other areas. Based on our analysis (using forward earnings consistent with the PE Ratio comparison), all three of the companies have payout ratios greater than our threshold. Wow! I was not expecting that. I knew tobacco companies had higher payout ratios to support higher dividend yields, but I wasn’t expecting all three companies to have payout ratios exceeding 60%.
- Increasing Dividends– We love increasing dividends. Why? Because we want our income streams to increase at a rate greater than inflation so we do not lose purchasing power with our funds. We calculated the one year and three-year dividend growth rates for each of the companies in the table below. PM has the largest average dividend increase over the last three years, averaging an increase of 9.12% while BTI had the highest dividend increase last year, increasing their dividend 11.42%. Overall, very strong growth rates for all three companies as they increased their dividend well over the inflation rate. These growth rates are much higher than I was expecting from the companies considering their current dividend yields, as I typically expect high dividend yielding stocks to grow at a lessor rate than low dividend yielding companies. One last item about the growth rate, all three stocks have dividend growth rates greater than my portfolio’s current weighted average. Which is a major plus considering that all three of the companies would increase my dividend yield and my portfolio’s weighted average growth rate. Fantastic news! One of my goals for the current year was to try and only add companies to my portfolio that would increase either (or both) my portfolio’s current dividend yields and/or my weighted average growth rate. I know that is not always possible, but luckily, all three of the tobacco companies would fit this bill! To see why I am so excited about this, read why your portfolio’s weighted average dividend rate is an important metric for your portfolio.
- 5 Year Average Yield- Lastly, in 2014, Lanny wrote a great article discussing why he reviews a company’s five-year average dividend yield. For this, I will only review PM’s average yield since it is the featured stock in this article. Over the last five years, PM has averaged a dividend yield of 4.17%, which is much lower than the company’s current yield of 4.85%. This could indicate two things: the dividend is too high and could be potentially cut or the stock is under valued and is set to appreciate. Considering PM recently announced their dividend increase, I am going to assume the latter scenario is more likely than the former.
Summary
I am a little surprised by the results of the analysis, considering I was expecting PM to perform well in our screener. However, based on the results of the screener, PM does not pass our screener as the company failed both the PE Ratio and payout ratio screens. The bigger question is should I consider purchasing BTI over PM? After all BTI would provide me with the same international tobacco exposure as PM and the company performed better in our stock screener. Regardless, since neither PM, BTI, or MO passed all three metrics of our stock screener, I will not be purchasing their shares with my excess capital. Going forward, I will add PM and BTI to my watch list to see if the stocks depreciate and become a greater value.
What are your thoughts on the analysis? Have you purchased shares in PM, BTI, or MO recently? If so, why did you select one company over the other? Would you consider purchasing one of the stocks even though they have a high payout ratio? Please let me know your feedback of this analysis!
-Bert
I’m staying out of tobacco industry due to personal reasons. From a pure fundamental analysis point of view BTI seems to be a better choice.
Bert,
“I knew tobacco companies had higher payout ratios to support higher dividend yields, but I wasn’t expecting all three companies to have payout ratios exceeding 60%.”
That is a mistake with the premise of the article. Tobacco companies always have high payout ratios. Altria actually targets an 80% payout ratio, last I checked. Just a part of the industry.
That said, I like PM the best over the long haul, due to their strong brands and leading global market share. The drawbacks are largely the same for them and BTI, so I’d prefer the stronger brands.
Sounds like none of them really fit for you and your portfolio right now. And there’s nothing wrong with that. 🙂
Cheers!
Fair point Mantra! I know we usually focus on the 60% payout mark for our portfolio, but there are times where that is just not applicable. As you pointed out, if the tobacco market typically pays a higher payout ratio (Which it definitely appears to be the case), then I should be willing to make an exception to the metric. I agree with your final conclusion. If a company doesn’t fit, it doesn’t fit at the end of the day. I like both PM and BTI, and I think it would be nice to diversify among the tobacco industry. But a move doesn’t have to be made at this moment. If BTI slides before its dividend announcement next month or PM continues its downward trend, I may not be able to hold back from purchasing the stock.
Thanks for stopping by!
Bert
The headline earnings and P/E are a starting point in your evaluation. This only applies at any given point in time, and not over time.
When you have been around a while, you learn that it is more important to own high quality businesses with demonstrated moats. The financials at any given time may not look good, but realize that the conditions change over time (e.g., forex).
The question is, does PM have a good business that is worth owning? The business has some characteristics that are exceptional, such as operating margins above 40%, consistent earnings (currency neutral), and pricing power in their products. To compare, AAPL and MSFT have 30% margins. To get higher than 40%, you need to go to financials such as V and MA.
At this level, BTI and PM are very similar (in fact MO and LO as well). However, one could argue that the earnings quality isnt as high as MO because PM/BTI have currency risk.
SFI,
Thanks for stopping by. I agree, the metrics we use are just the starting point and help us identify if a dividend stock is potentially a value at any given moment. With that being said, once we identify a stock, the detailed research begins and we begin reading 10-K/10-Qs, press releases, annual reports, etc. to focus on the areas you mentioned were critical. Based on this filter, I spent an hour or so reading up on BTI to assess the moat and determine if BTI is that high quality business worth owning.
I love companies that have strong brands because I believe that is a major contributor to a company’s moat. PM has some of the most recognizable brands in the cigarette industry and has the leading seller worldwide in Marlboro. Thanks for bringing up the facts about the margin, I didn’t realize the tobacco industry operated with such high margins. Good to know.
Thanks for stopping by!
Bert
Not a tobacco fan, but PM is a strong company perfect for long-term investment. As Dividend Mantra wrote, their brands are really strong too. Question is: do you really NEED tobacco companies in your portfolio? Maybe another type would be a better fit in regards to your criteria. I’m not sure where you’re at in your diversification, but its worth taking your time to find a company you’ll really like and have trust in.