AMM Dividend Newsletter Vol. 20: Dividend Growth, The Ion Engine of Your Portfolio

This is from the AMM Dividend Letter released June 4, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Mankind is going to Mars. It may not happen in our lifetime, but momentum is building for a manned mission to the red planet. The ion engine may very well get us there.

Rocket fuel combustion is great for getting things up into space quickly but a poor choice for long haul space flights. This is the job of the ion engine. Ion engines require significantly lower amounts of fuel and power than a traditional rocket engine and they can run for an extremely long time. NASA ran one in their lab non-stop for over 5 years.

The real appeal for ion engines, and why it is a poor propulsion choice for a certain Galactic Empire’s space fighter, is even though the thrust it creates is small, each ion ejected adds to the spacecraft’s acceleration. Ion by ejected ion the spacecraft’s acceleration compounds over time to reach the incredible speeds necessary to traverse the expanses of space.

We’re not NASA scientists and we’re not trying to do something as dangerous as getting you to Mars but we are trying to do something that is probably much more important to you. We’re trying to build a sustainable and growing income stream in retirement through a series of small incremental gains in income and principal over time. Small gains over a long period add up to something significant.

It would be very easy for us to chase recent performance and buy the hottest most popular names in the stock market. We’re not effective at this type of investing. We would be acting as the rocket fuel filled booster in this strategy. We might be able to increase your account balance quickly with a couple of lucky (and risky) picks but we likely wouldn’t maintain the “thrust” and eventually we would come crashing back down to Earth.

Instead we want to be the ion engine for your portfolio. Investing in high-quality dividend paying companies should both minimize the odds of a portfolio catastrophe, and grow your wealth and dividend income on your journey to the far reaches of retirement.

Sincerely,
Your Portfolio Management Team

Dividend Stock in Focus

Philip Morris (PM): $81.83*
*price as of the close June 4, 2015

Philip Morris was founded in England in 1847 on the famous Bond Street and began life as a niche cigarette manufacturer. Seeking greener pastures, Philip Morris moved to New York in 1902. Then in 1919 through a series of transactions Philip Morris became a U.S. company but it kept its English trademarks. The most important one being named after the Duke of Marlborough.

The 1920s were a time for women’s suffrage and the rise of the jazz age. To finds its niche and to profit on the rise of a more independent, “decent and respectable” woman Philip Morris changed Marlborough to Marlboro and introduced its “Mild as May” slogan. Philip Morris also introduced the ivory tip of grease-proof paper to prevent its cigarettes from adhering to a woman’s lipstick. Philip Morris found its niche, Marlboro would be a woman’s cigarette.

Then in 1953 a new type of magazine was launched.

Image from On The Cover Of... Click image to enlarge.

Image from On The Cover Of… Click image to enlarge.

Playboy was a natural home for tobacco advertising and for selling the old-fashioned manly virtues of smoking. Philip Morris, a dedicated woman’s cigarette brand, obviously needed some help appealing to men. Enter Leo Burnett, a Chicago ad man. Leo created the Marlboro Man, a play on the epitome of American masculinity. If you smoked and wanted to look manly while smoking then you smoked Marlboros.

Click image to enlarge.

Click image to enlarge.

The Marlboro Man was an extremely effective marketing tool and helped transform Philip Morris from a niche woman’s cigarette manufacturer in to a global powerhouse.

Marlboro remains the most popular cigarette brand in the U.S. with a 42.6% market share. Internationally Marlboro has been the number one cigarette brand since 1972. Marlboro sells more cigarettes than the 2nd & 3rd international brands combined. American Machismo sells well.

*All historical references are from Tobacco: A Cultural History of How an Exotic Plant Seduced Civilization

Dividend History:

The new Phillip Morris International was spun-off from Altria (MO) in early 2008. Altria retained the domestic tobacco business, a finance company, and the 26% stake in brewer SabMiller. Philip Morris became focused on the international business.

Philip Morris started paying a dividend in 2008 but didn’t start paying a full year’s worth of dividends until 2009. Since 2009 Philip Morris has grown its yearly dividend per share at a compound annual growth rate of 9.58%.

From S&P Capital IQ. Click Image to enlarge.

From S&P Capital IQ. Click Image to enlarge.

Philip Morris’ current dividend yield is 4% and its payout ratio is 83%. This is a higher payout ratio than our typical dividend strategy holding; however since Tobacco companies only need to reinvest a relatively small portion of earnings back in to the business they are able to pay out more of their earnings in dividends.

Catalysts for Dividend Growth and Price Appreciation:

Southeast Asia

Southeast Asia contains a large percentage of the world’s population; it is also contains some of the highest smoking rates in the world. Indonesia has one of the highest smoking rates with 67% of males age 15 years or older identifying as a smoker.

Philip Morris has a 31% market share in Indonesia and a 90% market share in the Philippines, and remains highly profitable throughout the region. If smoking rates in Southeast Asia remain high and Philip Morris can defend and grow its market share while maintaining its pricing power then the area will remain a cash cow for the company. Especially, if Philip Morris can improve its operational efficiency. More on this below.

Africa

Africa has the fastest growing population in the world and remains an area of opportunity for tobacco companies.

From the LA Times.

“You don’t have a lot of smokers now, which means there’s a lot of growth potential,” he said. “In Africa, population growth is rapid. Over the next 20 years, the one region where smoking prevalence is going to rise under any circumstances is Africa.”

A 2011 study by the University of Michigan found that without more action by African nations to discourage smoking, the percentage of smokers will rise from an average 16% to 22% by 2030, a massive increase given U.N. predictions that sub-Saharan Africa’s population will rise by half a billion, to 1.3 billion, by then.

Philip Morris’ has a fairly small presence in Africa right now but the company is focused on growing its brands within Africa. Cigarette volumes in the developed world are declining. The emerging parts of the world, like Southeast Asia and Africa, are where cigarette sales are growing. It is important for Phillip Morris to gain market share in Africa to fuel future growth.

Capital Efficiency

The chart below shows Philip Morris’ Return on Invested Capital (blue bar) and Return on Tangible Capital (orange bar).

Click image to enlarge.

Click image to enlarge.

Philip Morris requires very little capital to reinvest back into its business in order to generate more sales. Higher sales with low capital requirements means Philip Morris can return more to its shareholders through increased dividends and share buybacks.

Improved Operational Efficiency

Asset turnover is the amount of sales or revenue generated per dollar of assets. It is an operational efficiency metric on how well a company is utilizing its assets. Philip Morris has a good asset turnover ratio but it can do better.

The chart below shows the asset turnover for Philip Morris (blue line), Imperial Tobacco (purple Line), British American Tobacco (orange Line), and Lorillard (red line).

From S&P Capital IQ. Click image to enlarge.

From S&P Capital IQ. Click image to enlarge.

Philip Morris is right in the middle. By Improving its cost structure and manufacturing strategy, Philip Morris can increase its asset turnover, turn inventory and finished goods into cash quicker, and increase its returns on capital.

Pre-Mortem (Potential Risks to our Thesis):

Increased Foreign Legislation

While the major tobacco companies are financially stable, they operate in an industry susceptible to a high degree of legislative and regulatory risk.

Currently, one of the bigger threats to tobacco companies and their branding strategies is plain packaging laws. Under these laws, all cigarettes brands are packaged in the same nondescript box and the same drab coloring. Only the name of the brand at the bottom of the box would differentiate it from a competitors box. Most plain packaging laws also include graphic images of the perils of smoking on each box to help deter people from smoking.

Increased regulation tends to lead towards less smokers, especially if it raises prices. Lower smoking rates and number of smokers in foreign markets will hurt Philip Morris’ future growth. Profitability seems to be less effected as evidenced with U.S. tobacco companies whose profits have continued to grow while smoking rates have fallen substantially, from 43% in 1965 to around 18% today. However, profitability can only last so long if less and less people start smoking.

Stronger Dollar

While Philip Morris is an internationally focused tobacco company, it is still domiciled in the U.S. and its financials are reported using the U.S. dollar. When the U.S. dollar is strong and getting stronger to the rest of the world’s currencies then Philip Morris’ revenue and profits will take a currency conversion hit. These are short-term fluctuations and Philip Morris can hedge itself using currency futures contracts. Of course there is a flip side to this coin, as a decline in the dollar would result in a currency conversion benefit for the company’s earnings and revenue.

Conclusion:

The most hated companies in the world are Tobacco companies. The arguments against tobacco companies are hard to refute. For these reasons people avoid owning tobacco companies which keeps the price of their stocks cheap and their dividend yields high.

Buying companies that generate high returns on capital cheaply is a recipe for strong investing returns. Using Phillip Morris’ average operating and profit margins from the last 9 years and a below consensus growth rate we still come up with a value of $98 per share. If Philip Morris grows faster, or improves its operational efficiency, and expands its margins then the company is worth a lot more. At $81.83 per share we get to buy a company that generates very high returns on capital at a cheap price while earning an above average 4% dividend yield.

Chart courtesy of Stockcharts.com. Click image to enlarge.

Chart courtesy of Stockcharts.com. Click image to enlarge.

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.