Philip Morris Yields 6% But Faces Credit Downgrade Risk (NYSE:PM)

PM is undervalued

The thesis of this article is to explain the risks hidden behind Philip Morris International Inc.’s (NYSE:PM) dividend yield. The chart below summarizes consensus ratings of the stock’s dividend grades and compares them to the sector median. As seen, PM’s dividend yield across all metrics receives an A grade. It is currently yielding almost ~6% (5.85% on an FWD basis to be exact), far higher than its 4-year average dividend yield of 5.41% and also the sector median (2.69% FWD and on average 2.39% for the past 4 years).

Such dividend yield implies undervaluation by a large margin. A brief look at its P/E provides another indication of undervaluation. As seen in the chart below, it is trading at about an 11% discount from its past 5-year average FWD P/E and a discount of almost 20% relative to the sector median.

What is the catch, then?

Despite the attractive yield and valuation, I am concerned about its dividend safety. The chart below summarizes PM’s EPS dividend payout ratio compared to its historical average (top panel) and its cash payout ratio compared to its historical average (bottom panel). As seen, both its EPS dividend payout ratio and cash dividend payout ratio are currently above 100%. In contrast, its historical averages are around 85-90% for the EPS payout ratio and around 70-80% for the cash payout ratio.

Looking ahead, I don’t think the payout ratio would come down quickly. The strength of a business’s balance sheet is an important factor for its dividend safety. Unfortunately, it’s a factor that is not captured in the simple payout ratios. We have been reminding our readers whenever we can to dig beyond those simple payout ratios.

For PM, the news is quite concerning the way I see it. Its credit ratings were recently affirmed by Fitch at “A,” and this is good news. But the bad news is that its outlook is revised downward from stable to negative. You can read Fitch’s rationale for the downward revision in more detail following the report entitled “Fitch Revises Outlook on Philip Morris International to Negative, Affirms at ‘A’.” The gist is quoted below. It is slightly edited by me, with emphasis added by me.

Heightened Leverage Until 2026: PMI’s Fitch-calculated 2023 net EBITDA leverage is projected to remain high at 3.1x after its over USD16 billion debt-funded acquisition of SM. This is outside the ‘A’ rating category, and Fitch projects PMI’s net leverage will only fall to the pre-acquisition level of below 2.0x after 2026. In our view, PMI’s ability to reduce its debt by 2025 as originally anticipated will be hampered by likely weak FCF generation in 2023 and 2024 following inflation pressure, currency headwinds, increased interest payment relating in part to SM’s debt-funded acquisition and the uncertain outcome of the German tax surcharge ruling on heated tobacco units.

Digging a bit deep, I see good reasons for the above concerns. There are various reasons to keep its balance sheet stretched (or even further stretch it) in the coming 2~3 years. The top ones on my mind are its acquisition of Swedish Match (“SM”), the uncertainties surrounding the degree of success of its launch of IQOS ILUMA in the U.S., and inflationary pressure.

These concerns are supported by PM’s financial data. The chart below depicts PM’s free cash flow generation lately (top panel) and its debt to EBITDA ratio (bottom panel). As seen, PM’s free cash flow generation peaked in 2022 at around $12B and then dropped substantially to the current level of $7.88B. PM’s debt-to-EBITDA ratio has also been climbing up gradually over the years. But it has largely been stable at a level slightly below 3x since 2016 and even decreased a bit during 2022. However, its debt to EBITDA ratio has sharply increased in the past 1 year or so to the current level of 3.56x, the highest level in its history.

All told, the substantially reduced FCF generation and the current high leverage ratio form a very concerning combination in my view, not only for its future dividend coverage but also for its capital expenditures and debt services. In the absence of clear deleveraging toward 2.5x in the next 12-18 months, PM could face a credit rating downgrade, which could cause even higher borrowing costs and further exacerbate its FCF issues.

Profitability and growth

I have been focusing on the negatives so far, and the article won’t be balanced if I do not point out the strengths as well. First, the business still has a healthy growth curve in the long term in my view. Consensus seems to share this view and projects a CAGR growth rate of 6.6% in the next few years, as seen in the next chart. To wit, its EPS is estimated to be $6.35 in FY 2024 and to grow to $8.76 in 2028. Such a growth rate is healthy enough to generate satisfactory returns in the long term, given its current valuation. Under this growth curve, the forward P/E would only be about 10x by then.

Such a long-term projection makes good sense to me, given PM’s historical ROCE (return on capital employed). It is in line with our own estimates. As seen in the second chart below, it has maintained an average ROCE of around 62% in the past. Its effective reinvestment rate was around 5% based on my analysis, resulting in an organic growth rate of around 3% (62% ROCE x 5% reinvestment rate). Given the tobacco industry’s demonstrated record of pricing power, adding an inflation factor of 2~3% would push the nominal growth rate to the 5% to 6% range.

Other risks and final thoughts

Some additional risks that PM faces include the risks common to the tobacco sector, such as regulation risk, the decline of smoking products, and litigation. There are some risks that are more particular to PM, but not to other tobacco stocks. Philip Morris is more reliant on sales in emerging markets than some of its peers. Emerging markets are generally more price-sensitive than developed markets, and such dependence also makes PM more sensitive to FX exchange rate fluctuations.

To conclude, due to the mix of factors mentioned above, I am rating PM as a hold. The stock features a low P/E ratio and a high dividend yield, which makes it worthwhile to hold for existing investors, especially for income investors and value seekers. Furthermore, the company has a good track record of maintaining solid profitability and a robust ROCE. However, potential investors need to be aware of its FCF and debt issues in the near term. My view is that there is a realistic chance for a credit rating downgrade in the next 2 years or so. If this materializes, it would further exacerbate Philip Morris International Inc.’s issues and market sentiment.