Why Philip Morris International is a great buy today

What a busy month for me! A couple of weeks ago, I purchased shares in Target Corporation (TGT) and figured that might be it for the month. I actually think successful investing should be akin to watching paint dry or grass grow; it just shouldn't be that exciting. However, I ended up buying and selling much more this month than I initially anticipated. I sold my entire position in Intel Corporation (INTC) after the seventh straight quarter with no dividend raise, and subsequently added to my position in The Coca-Cola Company (KO) and initiated a position in Omega Healthcare Investors Inc (OHI).

I don't expect this type of activity to continue throughout the year. I like boring months where I make a purchase or two, reinvest dividends and march ever closer to early retirement. However, the recent pullback in the broader market, and more specifically shares in high quality companies I regularly track made it tough for me to ignore some of the deals I was starting to find. And one company in particular forced my hand, as I dipped into my reserve capital and made yet one more stock purchase for the month of January.

I purchased 15 shares Philip Morris International Inc. (PM) on 1/30/14 for $79.14 per share.

Philip Morris International is the world's largest publicly traded manufacturer and seller of cigarettes and other tobacco products, with sales in approximately 180 countries. PM owns many major brands, including: Marlboro, Parliament, L&M and Chesterfield. Marlboro contributed 33% of total volume in 2012. 

I'll be honest and say that I wasn't particularly interested in adding to my investment in Philip Morris because it's already one of my largest positions, at approximately 5.5% of my portfolio. Furthermore, I have a rather large allocation to tobacco in general.

However, shares in PM have continued to slide downward week after week in a steady decline that started at the end of 2013. It appears that after Standpoint Research initiated analyst coverage on Philip Morris at the beginning of January and one of their analysts, Ronnie Moas, rated PM as a sell citing moral concerns that shares in PM accelerated their trend downward. Over the last 30 days PM shares are down -10.32%. That compares quite unfavorably to the S&P 500 over this same time period - down some -3.5%. However, it's this kind of underperformance from a high quality company like Philip Morris that gets me very excited. When everyone else is fearful it's often not a bad idea to be greedy, assuming the fundamentals are solid and a company is qualitatively attractive. 

Overall, the fundamentals remain strong here. Philip Morris presented at the 2013 Morgan Stanley Global Consumer Conference and I liked what I saw. Management continued to warn of currency headwinds, but currency fluctuations tend to even out over the long haul. They revised guidance for 2013 with a diluted EPS range of $5.37 to $5.42. They had some great slides showing that while volume declines worldwide in the general tobacco industry have been notable over the last few years, the company has been able to mostly weather this storm quite well. Moreover, the company has managed to increase its market share of the international cigarette market substantially over this time period, up from 25.5% in 2008 to 28.8% in 2012.

Philip Morris has only been a publicly traded company since 2008, after being spun off from Altria Group Inc. (MO) to protect shareholder's interests and allow the international arm to focus on operations without worry of U.S. litigation. Earnings per share have grown at a compounded annual rate of 11.71% during the 5-year period from 2008-2012, up from $3.32 to $5.17. In addition, revenue has a CAGR of 5.11% during this same time frame - increasing from $25.7 billion to $31.3 billion. These are rather robust growth rates considering that Philip Morris has to continually deal with volume declines industry wide. Forecasts call for a -2% to -3% volume decline across all international markets (excluding China and U.S.) for the cigarette industry in 2014.

The dividend growth has also been very healthy. Philip Morris has a 6-year track record of dividend growth, and the raises have been substantial. The 5-year dividend growth rate currently stands at 28.4%, but going forward I expect lower, but still healthy raises in the high single-digits to low double-digits. The yield on shares at my price is 4.75%. 

The payout ratio currently stands at 71%, so there is room for dividend growth before the payout ratio becomes troublesome, especially with continued robust growth in EPS. The company does target a 65% long-term payout ratio, so EPS will have to continue growing to substantiate further dividend raises. The dividend is also comfortably covered by free cash flow, with a payout ratio against FCF at 68%. And speaking of FCF, Philip Morris is a cash flow machine. PM manages to convert revenue to FCF at extremely attractive rates, and currently leads many other high quality companies like Johnson & Johnson (JNJ), The Coca-Cola Company (KO) and McDonald's Corporation (MCD) in terms of free cash flow as a % of net revenues - currently at 29.1%, from 2008 to September 30, 2013. 

And it's not just cash dividends that Philip Morris uses to reward shareholders, as they're also currently in the midst of a massive buyback program - using low-cost debt to do so. The company initiated a 3-year $18 billion share repurchase program in late 2012, and I find the pullback in shares as an opportunity for not only me to increase my position in this cash cow, but also for management to buy back shares at advantageous prices. 

The balance sheet is a weakness for PM, with over $17 billion in long-term debt, as the aforementioned massive repurchase plan has added debt at the cost of buying back shares. Overall, management appears to be prudent with this maneuver as it allows the company to take on debt at historically low interest rates to retire shares that would otherwise pay out a high dividend. However, the interest coverage ratio remains high at 16 so Philip Morris can easily cover its interest obligations here.

One major wild card here is China. Currently, PM has a deal for licensed production of Marlboro in China (2.0 billion units in 2012) and an international joint venture with China National Tobacco Corporation (CNTC). However, this deal is just a tip of the iceberg when it comes to potential in China. Cigarette industry volumes are expected to reach 2.5 trillion units in 2013, so it's a market with massive potential but, unfortunately, mostly controlled by a state-operated monopoly.

Growth could also come by way of electronic cigarettes (e-cigs) and next-generation reduced-risk products. Philip Morris has determined 2014 to be an investment year in the company, as it develops manufacturing capacity for 30 billion unitsof its reduced risk products and rolls out commercial pilot tests in select cities in the latter half of the year. The company plans on rolling out its first next-generation product (branded Platform 1) in early 2015 after numerous clinical trials. Philip Morris International has also formed a strategic partnership with its domestic counterpart Altria Group Inc to commercialize reduced-risk products and e-cigs. The company plans to launch an improved-taste e-cigarette in 2014, and the growth potential here is pretty substantial if the U.S. is a good example for the global market.

Philip Morris continues to execute and leverage its competitive advantages, including a dominant brand in Marlboro which allows it pricing power and scale in the face of rising excise taxes and increasing regulation across the globe. It maintains strong cash flow, robust dividends, a strong buyback policy and growth looks set to continue with traditional tobacco products, reduced-risk next generation products and e-cigs. S&P Capital IQ predicts 9% EPS CAGR over the next 3 years.

However, risks are certainly high with the aforementioned litigation and excise taxes. While these produce a high barrier to entry, they also make it more and more difficult for the company to pass on hikes as eventually it is hard for consumers to afford some of the premium products that Philip Morris markets. This is partially offset by the breadth of products and geographical diversification across the globe, so that no one market can dominate PM's growth profile. Additional risks remain in plain packaging mandates, recently passed in Australia and considered in other major markets throughout Europe.  

Shares in PM are currently trading for a P/E ratio of 14.8, which is favorable to the 5-year average at 15.7. Considering the growth potential of this company, and the broader market's run over the last year, I consider PM shares to be quite attractively priced here. I valued shares using a typical Dividend Discount Model analysis with a 10% discount rate and a lowly 6% long-term growth rate (substantially lower than PM's historical average) and using the preceding input the fair value on shares comes out to $99.64. I'd be comfortable with saying the margin of safety on shares at today's price is at least 15%, assuming the company continues executing properly. 

This purchase adds $56.40 to my annual dividend income total based on the current quarterly payout of $0.94 per share. With the addition of these shares, I now own 115 shares of Philip Morris International. 

My portfolio still currently holds 43 positions, as this was an addition to an existing investment. 

I'm going to include current analyst valuation opinions below, as I use these to concentrate my reasonable valuation estimate.

*Morningstar rates PM as a 4/5 star valuation, with a fair value estimate of $93.00.
*S&P Capital IQ rates PM as a 4/5 star Buy with a fair value calculation of $76.00.

I'll update my Freedom Fund in early February to reflect my recent addition.

Full Disclosure: Long TGT, KO, OHI, PM, MO, JNJ, KO, MCD

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]