The idea behind buying dividend stocks is that they provide a healthy cash inflow regardless of what the stock’s performance does after the purchase. As long as the dividend isn’t cut, a $.75/share quarterly dividend remains at $0.75 regardless of whether the shares trade higher or lower. The buyer’s dividend yield is locked in at the purchase. This can be a fairly attractive investing strategy if done well.
A savvy investor can take at least two approaches to buying dividend stocks. The first is waiting patiently for the share price of an attractive company to fall, then buying when the yield is high enough. The second is sorting the universe of stocks by their current dividend yields and selecting the most attractive at that time.
Investors using the second approach, which is generally the most commonly practiced, will want to be selective. Not all dividend yields are created equal. Two seemingly identical tobacco stocks illustrate the difference.
Shares of Altria (MO) and Philip Morris International (PM) both offer attractive dividend yields – 8.8% for Altria and 5.4% for Philip Morris. Both are in the same business (tobacco) and, most visibly, both produce and sell Marlboro cigarettes, the most popular premium cigarette brand around the world.
But behind this seemingly common façade are two very different pictures. Altria’s Marlboro franchise is restricted to the United States, while Philip Morris has the rest of the world. This provides Philip Morris with the potential to grow its core business, while Altria’s entire business is in secular decline and trapped in a single (albeit huge) tobacco market. Not only are U.S. cigarette volumes declining, oral tobacco products are flattish as well (and only marginally meaningful at about 11% of Altria’s revenues).
Altria has no convincing prospects for new alternative products following its failed efforts in JUUL (resulting in a near-total write-off of its $13 billion purchase), Cronos and IQOS. Its stake in Anheuser-Busch InBev (BUD) is an unrelated asset that will likely be liquidated over time. Alternative products generate essentially zero revenues for Altria.
Philip Morris, however, has a strong alternative product portfolio with healthy growth prospects. It owns essentially global rights to the profitable, sizeable and growing IQOS products, as well as a range of other smoke-free products. Nearly 35% of its total revenues in the most recent quarter were from smoke-free products. The company’s recent acquisition of highly regarded Swedish Match, alongside IQOS, provides it with a valuable entre in the United States, threatening Altria’s market share across the board.
Financially, Altria’s dividend paying ability appears to be a mirage, even as its recent 4.3% dividend increase works to favor its image as reliable. Nearly 85% of its free cash flow is consumed by the dividend. As Altria’s profits grind lower, and as it attempts to keep increasing its payout, eventually the dividends will consume over 100% of its free cash flow. The company can liquidate its Anheuser-Busch stake to cover the shortfall, but the trajectory is clear: Altria is slowly but surely being drained of value.
An accelerant in Altria’s decline is its reliance on product price increases. Flat revenues suggest stability, but this stands on the shoulders of consumers’ willingness to pay ever-higher prices. Year to date, Altria’s smokeable volumes have declined 10%, implying an 11% price increase. Higher prices represent nearly pure profit – any deterioration in pricing power erodes free cash flow. Further, higher prices drive consumers to lower-priced brands, weakening Altria’s volumes.
Philip Morris, on the other hand, has stronger revenue and cash flow growth to power its growing dividend. And, its dividends consume only 74% of its free cash flow, leaving an incremental 11% of its free cash flow, relative to Altria, to maintain its financial flexibility, fund incremental growth and generally support its operations.
Does Altria have turnaround potential? We see little chance. The company’s core business is strategically and geographically boxed in with essentially zero revenue growth or margin expansion opportunities. Its ability to expand by acquisition is financially constrained by its limited surplus cash flow (and partly by its already-full debt capacity), while its history of blundered acquisitions will likely impair its willingness to expand by buying new opportunities.
Philip Morris looks like the clear winner in a head-to-head battle of these two high-dividend tobacco stocks.
Currently, the Cabot Turnaround Letter has 33 Buy-rated turnaround stocks on its recommended list. Check out our advisories for more information about how our advisories can help you find attractive turnaround stocks.
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