Are Philip Morris' Best Days Behind It?


Anti-smoking campaigns are on the rise globally, and major international bodies such as the World Health Organization are doing all they can to curb the appeal of smoking. Yet shares of Philip Morris (NYS: PM) have been on a tear in recent years, having more than doubled between 2009 and today.

However, a recent decision in Australia that bans logos on cigarette packaging could spell trouble ahead. Can Philip Morris keep going strong?

Share buybacks and dividends
There's no doubt the company has been both profitable and shareholder-friendly. Since March 2008, when it was spun off from Altria Group (NYS: MO) , Philip Morris has returned a total of around $40 billion to shareholders through dividends and share repurchases.

The company is just completing a $12 billion share buyback implemented over three years and plans to repurchase an additional $18 billion in shares over the next three years. The new buyback program commenced at the beginning of August.

The company's dividend yield, at 3.4%, is relatively unattractive compared with an industry average of 5.1%. However, its dividend is growing faster than the industry's average and looks much more sustainable than that of its peers. Its payout ratio, at 57%, is lower than the industry average of 62%.

The company also yields significantly more positive free cash flow compared to industry competitors British American Tobacco and Reynolds American (NYS: RAI) .

Philip Morris' five-year average annual dividend increase of 42% is impressive. And its five-year average annual growth in EPS and revenue stands at 13.5%, compared with an industry average of 5.9%, and 11.7%, compared with the industry's 6.8%, respectively. Return on total capital is more than twice the industry average. However, the company's debt-to-capital ratio is more than double the industry average, and, surprisingly, its net profit margin of 12% trails the industry's average of 15%.

Smoking trends around the world
Some have called attention to tightening regulatory pressures in the U.S. as potential risks to the company going forward. But they may be underestimating the huge runway for growth in international markets. Not only are these markets less regulated, but they're also home to young and growing populations who love to smoke. A recent comprehensive international study by medical journal The Lancet found that two out of five adult men in developing countries smoke or use tobacco, and women are becoming smokers at younger ages. The study also found that men in low and middle-income countries tend to smoke disproportionately more than women. The average rate for men was a whopping 41%, compared with 5% for women.

Still, female smokers are on the rise globally, with nearly a quarter of Polish women reported as smokers. Despite several initiatives to curtail smoking habits across the world, most developing countries have very low quit rates for smokers of both genders.

As terrible as these developments are for these peoples' health, they're great news for Philip Morris' bottom line.

High-growth Asian markets
While Philip Morris' dividend yield is lower than that of its peers, especially compared with Vector Group's (NYS: VGR) monstrous 9.3%, the company's strong international exposure and tremendous brand power through Marlboro should be enough to compensate. Asia, in particular, holds vast promise for the cigarette maker. China, Indonesia, and India all have large and growing populations that represent a massive potential customer base.

Take Indonesia, for example. It's the fourth most populous country in the world, and Philip Morris now commands a whopping 33.5% market share there. The archipelago nation is something of a haven for smokers and tobacco companies alike. Though anti-smoking campaigns are on the rise, smoking remains both highly prevalent and socially accepted, with an alarming 32% of adults qualifying as smokers. Tobacco products are the No. 2 item in household expenditure, just after rice, according to the country's statistics bureau.

The Philippines is also a major market. Philip Morris boasts a dominant market share here as well, and in 2010, it started a joint venture with Fortune Tobacco, a cigarette company targeting low- and middle-income Filipinos. Together, they control around 90% of this $1.7 billion market.

Going forward, the company sees significant growth potential among Southeast Asian women. Less than 10% are smokers, but rates are rising rapidly, especially among girls under 16 in the Philippines, Malaysia, Indonesia, and Vietnam. With crafty marketing ploys to lure women, like selling cigarettes in small "lipstick packs" that offer the appeal of high-end cosmetics, the rate of female smokers should continue to rise.

Final thoughts
The stock isn't exactly cheap. Shares trade at a premium to peers Altria, Lorillard (NYS: LO) , and Reynolds American on a price-to-earnings and price-to-sales basis. Still, I think the premium may well be deserved, given the company's much stronger growth prospects and its broad exposure to less-regulated and higher-growth international markets.

A risk worth noting, however, is if Australia's recent court decision to ban logos on cigarette packs gains traction in Philip Morris' most important markets, including Indonesia and the Philippines. In my view, while it's certainly a meaningful risk, there are important forces mitigating it. For one, there's the economic impact of Big Tobacco. In Indonesia, for example, the industry employs millions and is expected to generate $8.45 billion in tax revenues this year. That fact alone gives Philip Morris major bargaining power and should allow it to continue bypassing regulators.

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Editor's note: A previous version of this article misstated the relationship between Philip Morris and Altria Group, and also misstated the nature of British American Tobacco's and Reynolds American's cash flows. The Motley Fool regrets the error.

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Fool contributorArjun Sreekumarowns no shares of any companies listed above. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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