Trust the Marlboro Man

07/01/2010 9:02 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, and analyst Philip Gorham foresee progressively higher payouts by Philip Morris International, which already yields a soothing 5%.

Philip Morris International (NYSE: PM) owns seven of the leading 15 international cigarette brands, including the iconic Marlboro. The firm is the dominant player in the European Union and holds leading positions in most Eastern European, Middle Eastern, Asian, and African markets. Strong market share positions, which give the firm economies of scale and premium positioning of its brand portfolio, have been the primary drivers behind industry-leading operating margins of around 40%, despite heavy investment in emerging markets.

Unlike tobacco firms in mature markets, Philip Morris is not merely managing a long-run decline in smoking. The firm has identified several Asian countries such as India, Bangladesh, and Vietnam as potentially lucrative growth markets. Philip Morris also has a small joint venture with China’s state-owned monopoly, though we anticipate that it will be many years before foreign firms make any significant headway into the lucrative Chinese market.

Although the firm has attractive long-term prospects, some short-term challenges threaten to weaken its near-term performance. Tobacco firms have tended to be more resilient than other consumer goods companies in an economic downturn, but they are not entirely immune. Volume may fall as cash-strapped smokers quit, and Philip Morris’ volume could further suffer if smokers in important markets such as Russia continue switching to cheaper brands.

In addition to these near-term headwinds, the firm could face longer-term threats from increased regulation, litigation, and costs. However, strong tobacco firms have fared well over long periods, and we believe that with the strength of its brand franchises and market-leading positions, Philip Morris is one of the best-positioned tobacco firms to provide solid returns for long-term investors.

With very strong cash flow and very high returns on internally reinvested capital, Philip Morris targets a 65% payout ratio, leaving room for share repurchases and fairly wide variations in foreign exchange rates. Net debt of $15 billion represents only 1.5 years’ worth of operating income and should not conflict with the firm’s generous dividend policy.

Though Philip Morris has only been a free-standing publicly traded entity since March 2008, we believe it has inherited both the means and the will to provide consistent dividend growth. On the basis of a 1% growth rate for volume (declines in the European Union offset by faster advances in developing markets), steady price increases, and share repurchases made with cash in excess of dividend requirements, we see Philip Morris’ dividend rising at an average clip of 7% a year. That said, currency fluctuations or shorter-run economic impacts may result in some lumpiness in this growth rate.

With a yield of 5.2% at our buy price of $45, we anticipate total returns averaging about 12% over the long run—high enough, in our view, to compensate for potentially unfavorable currency shifts.

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