Philip Morris International, Inc. Dividends: Smoking Hot or Unhealthy?

By Markets Fool.com

Source: Phllip Morris.

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Philip Morris International stock pays a big dividend yield of 4.9%. Tobacco is a highly profitable business, particularly so for Phillip Morris, which benefits from its powerful Marlboro brand and a major presence in emerging markets, where tobacco demand is much stronger than in developed countries. From this perspective, the stock looks like an attractive investment for dividend investors.

On the other hand, we are talking about the tobacco industry. The long-term trend for global demand for the product is not particularly encouraging, and everything seems to suggest that sales volume will remain under pressure for the foreseeable future. Regulatory hurdles and litigation risks are other important considerations to keep in mind.

Is Phillip Morris a smoking-hot dividend stock or a toxic business?

A solid track record
Phillip Morris owns the international rights to Marlboro, the leading brand in the global cigarette business by a wide margin. This puts the company in a strong competitive position, as brand recognition translates to pricing power in the industry. The company also sets itself apart from the competition through factors such as its wide distribution network and economies of scale.

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Source: Phillip Morris.

Management has capitalized on these strengths to deliver consistently growing capital distributions to investors over the years. What was a quarterly dividend of only $0.46 per share in 2008 has now more than doubled to $1 per share.

Phillip Morris has also implemented an active stock buyback policy, through which the company has reduced shares outstanding by almost 25% since 2008. A reduced share count allows Phillip Morris to pay more dividends per share with the same amount of cash flow, so large buybacks improve the company's ability to increase its dividend over time.

PM Dividend Chart

PM Dividend, data by YCharts.

Philip Morris recently suspended its buybacks, though. Management has attributed this decision to foreign currency headwinds, which are weighing on the company's cash flow and forcing Phillip Morris to prioritize dividends over buybacks as a means of capital distributions.

The company has not closed the door on the possibility of reinstating buybacks if conditions improve. However, to be conservative, investors should assume that share repurchases are not coming back for the time being.

Is the dividend sustainable?
Phillip Morris' total cigarette sales volumedeclined from 927 billion units in 2012 to 880 billion in 2013 and then to 856 billion cigarettes in 2014. This means a year-over-year decline of 5% in 2013 and 3% in 2014. Management believes the fall in unit sales will moderate in 2015, but the industry's long-term outlook is still quite dismal.

The company is compensating for the sales decline with price increases and cost savings, so both sales and earnings are still moving in the right direction when excluding the impact from currency fluctuations. Still, an investor is left to wonder how long Philip Morris can grow adjusted sales and cash flow when underlying cigarette demand is falling.

Companies in the industry are betting on e-cigarettes and product innovation to reverse the decline in tobacco sales, and Phillip Morris is following the same route. The company is promoting its iQOS device in the pilot markets of Nagoya, Japan, and Milan, Italy.

iQOS has a battery and a heating system, and users plug in a miniature cigarette containing tobacco sticks called Marlboro HeatSticks. The tube heats those sticks to turn the nicotine into vapor, but not enough to burn the tobacco like a regular cigarette.

Source: Phillip Morris

Management sounds optimistic about these kinds of initiatives and their potential over the coming years, but the jury is still out regarding the health impact of these products. Also, many smokers seem to use these devices as an intermediary step on the way to quitting smoking for good, so there is little sign of improvement when it comes to the overall demand picture in the tobacco business.

Phillip Morris produced $7.7 billion in operating cash flow during 2014. Capital expenditures were quite low -- less than $1.2 billion -- so the business brought in around $6.5 billion in free cash flow. Dividends consumed $6 billion over the year, so the current distributions may be sustainable, but Phillip Morris does not have much room to raise the payouts without issuing debt. This means dividend growth should be in line with sales and cash flow growth in the years ahead.

There is no reason to expect a dividend cut from Phillip Morris anytime soon, but dividend growth will probably be subdued in the coming years. Longer-term, falling sales volume is a major risk to consider. Unless the company proves to investors that it can reverse the decline in demand, investing in Phillip Morris could be hazardous to your health.

The article Philip Morris International, Inc. Dividends: Smoking Hot or Unhealthy? originally appeared on Fool.com.

Andrs Cardenal owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.