How Safe Is Philip Morris International Inc.'s Dividend?

By Investing Basics Fool.com

Source: Phillip Morris.

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Phillip Morris International stock offers many valuable traits for dividend investors. For starters, the stock pays a big 4.7% dividend yield, and the company has delivered consistent dividend growth over the years. On the other hand, tobacco is a very particular industry, exposing investors to considerable risks. This raises a big question for investors: How safe are the dividends from Phillip Morris?

Hot dividend growth
Tobacco is a remarkably profitable industry, especially for a company such as Phillip Morris, which owns the international rights to powerful brands such as Marlboro, Parliament, L&M, and Chesterfield, among others.

Consumers are typically very loyal to their preferred cigarette brand, and management estimates that Phillip Morris has market share of 40.4% in Europe, 27.6% in Russia, and 25.4% in Japan. When considering the company's top 30 markets in terms of operating companies income, or OCI, Phillip Morris owns a total market share of 37.5%.

Tobacco companies face serious regulatory limitations when it comes to marketing and advertising, and this can be a considerable advantage for a market leader such as Phillip Morris, since bans on advertising keep market share levels relatively stable and potential new entrants at bay.

The business generates big profit margins in the neighborhood of 39% of revenues at the operating level, and reinvestment needs are relatively low, allowing Phillip Morris to build a rock-solid track record of dividend growth over the years.

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Phillip Morris has been independently traded and operated since 2008, when the company was separated from Altria through a spinoff. Back then, Phillip Morris was paying a quarterly dividend of $0.46 per share, and distributions have increased consistently every year, more than doubling to $1 per share currently.

Looking forward
A solid trajectory of dividend growth says a lot about a company's financial strength and management's commitment to rewarding shareholders with growing payments over time. However, investment decisions need to be based on forward-looking considerations, not past performance, so it's important to to keep a close eye on the main industry trends and how they can affect Philip Morris' dividends in the future.

Governments and nonprofit organizations are implementing all kinds of initiatives to combat smoking and its negative impact on public health. Tobacco consumption around the world is on a secular decline, and Phillip Morris is not immune to this trend.

Phillip Morris' total cigarette sales volume declined from 927 billion units in 2012 to 880 billion in 2013, and then to 856 billion cigarettes in 2014. This represents a year-over-year decline of 5% in 2013 and 3% in 2014.

Management calculates that industry volume in the second quarter of 2015 declined by 3% year over year, and the company is forecasting a decline of between 3% and 3.5% in total industry volume during 2015. However, Phillip Morris is outperforming the industry on the back of strong brand power and market share gains, so the company's organic sales volume declined only 1.4% during the last quarter.

Unfavorable currency movements are hurting the company's revenues when measured in U.S. dollars, but sales in constant currency are still growing because of pricing gains. Net sales excluding currency fluctuations and acquisitions grew 4.5% in the second quarter, and management reaffirmed its guidance for an annual increase of between 9% and 11% in constant currency earnings per share for the full year 2015.

It's nice to see Philip Morris compensating the decline in sales volume with price increases and expanding profit margins. However, it's hard to tell for how long this trend can be sustained. After all, you can't keep raising prices and cutting costs indefinitely. Sooner or later, the decline in volume will cut into sales and cash flows unless the company can find new growth venues.

Companies in the industry are betting on e-cigarettes to replace traditional ones, and Phillip Morris is moving in the same direction. The company is rolling out its iQOS device in Japan and Italy, and management sounds quite enthusiastic about the potential opportunity in e-cigarettes. However, the jury is still out regarding the health impact of these products, and they're unlikely to have a big financial impact over the middle term.

Phillip Morris produced nearly $6.5 billion in free cash flow during 2014. Dividends consumed $6 billion over the year, so current distributions are sustainable, but the company doesn't have much room to raise payments without issuing debt. That means dividend growth should be in line with sales and cash flow growth in the years ahead.

There's 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 keep in mind.

The article How Safe Is Philip Morris International Inc.'s Dividend? originally appeared on Fool.com.

Andrs Cardenal has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.