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Tobacco stocks are beloved by their investors. Tobacco stocks such as Altria Group (NYSE: MO) have enriched shareholders by paying high dividend yields and raising their dividend payouts each and every year for decades on end.
One of Altria’s former subsidiaries, Philip Morris International (NYSE: PM) recently raised its dividend, but by a disappointing 2%. Philip Morris is struggling to grow sales and profit. The company is getting hit hard with a number of headwinds, including the strengthening U.S. dollar, and falling cigarette sales volumes in some of its key geographic markets.
Here’s why investors are right to be disappointed with the tiny Philip Morris dividend raise.
U.S. Dollar, Falling Volumes Weigh
As an international operator, Philip Morris suffers when the U.S. dollar strengthens against other foreign currencies. That is because sales conducted overseas are worth less when converted back into U.S. dollars. For example, Philip Morris’ total revenue declined 12% last quarter, from the same quarter last year. Over the first half of the year, adjusted earnings per share are down 8.8% year-over-year.
Unfavorable currency fluctuations caused Philip Morris’ revenue to decline by $1.3 billion just last quarter. But that wasn’t the only problem. Cigarette shipment volumes fell by 1.4% year over year. Management does not expect this to reverse quickly; for 2015, organic cigarette volume is expected to decline in the range of 1% to 1.5%.
This has put pressure on the company’s free cash flow. Over the first half of 2015, Philip Morris generated $2.8 billion of free cash flow, representing a decline from $2.9 billion in the same period one year ago. Philip Morris’ dividend cost the company $3.1 billion in that time, which should be a concern for investors.
The Philip Morris dividend payout as a percentage of free cash flow was 107% over the first half of the year. That is unsustainable. No company can distribute more cash in dividends than it generates in free cash flow for very long, without making up the shortfall somehow. Considering the cost of Philip Morris’ dividend is only set to rise going forward because of its recent 2% dividend raise, the company will need to slash costs to maintain its dividend.
Steep Cost Cuts Needed
As a result, Philip Morris is significantly cutting costs to give breathing room for the dividend. First, Philip Morris won’t buy back stock this year, which will help, since the company spent $3.8 billion on share repurchases last year. In addition, Philip Morris will seek hefty cuts from its manufacturing and production processes.
The good news on this front is that there are further cost-cutting opportunities Philip Morris can take advantage of, thanks to its massive scale. Tobacco companies enjoy robust free cash flow, as a result of very low capital spending requirements and excellent distribution capabilities. Last year, Philip Morris reduced its cost structure by $300 million, with further productivity measures in place this year. These include enhancing production processes, harmonizing tobacco blends and supply chain improvements.
These have helped meaningfully reduce expenses. Last quarter, Philip Morris cut its cost of goods by $318 million, or 11% year over year. In addition, the company reduced marketing, administrative and research costs by $148 million, or 8%.
Going forward, Philip Morris needs a positive catalyst to reignite growth. One catalyst could be the company’s iQOS line of products. These are an evolution on the e-cigarette trend that is a promising growth opportunity in the tobacco industry. Philip Morris’ reduced-risk products heat tobacco rather than burn it, which cuts down on ash.
However, if the U.S. dollar continues to strengthen and volumes of traditional cigarettes, Philip Morris’ most important product, decline further, the company may not be able to increase its dividend at all next year.
DISCLOSURE: Bob Ciura personally owns shares of Altria Group (NYSE: MO).
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