Philip Morris International (PM +1.55%) has always been thought of as a great buy-and-forget investment for any portfolio. Indeed, the company's defensive nature, robust dividend payout, and multi-billion dollar stock buybacks are all attractive qualities.
However, with the number of smokers worldwide in terminal decline, many investors have been expressing concern about Philip Morris' future. In particular, shareholders have expressed concern about the company's ability to sustain shareholder returns and drive profits higher.
There have also been worries about the future fortunes of Philip Morris' domestic peer, Altria (MO +0.34%).
Falling sales, rising profits
The biggest threat that has the potential to take down tobacco companies around the world is the global slump in cigarette sales. As of yet, though, it would appear that these tobacco behemoths aren't worried. They are using several tricks to not only maintain profits, but increase them.
One strategy that tobacco companies are using is to gradually increase the price of their products. Companies are doing this slowly to ensure that customers are not put off the products due to rapid price increases. For example, during 2013 the volume of cigarettes that Philip Morris sold declined by 5.1% in total. However, the company's sales jumped 3.3% as price increases offset declining volumes.
Back in the U.S., Altria has been using the same tactic. In particular, during December of last year, Altria added $0.07 per pack to the price of Marlboro cigarettes. This followed a similar $0.06 increase in June.
According to data supplied by the Tobacco Atlas, a pack of Marlboro cigarettes within the United States costs $6.36 on average. This implies that the total price increase of $0.13 per pack for this year would be a 2% rise all-in-all, which is not noticeable for the average consumer.
However, if we deduct the Federal and State taxes from the price per pack of cigarettes, an average pre-tax price per pack of cigarettes falls to around $3.36. This implies that while consumers have to pay up for a 2% price increase, tobacco companies benefit from a 4% underlying rise.
We can factor this into Altria's results to see how it helps keep the company's profits rising.
During 2013, the volume of cigarettes sold by Altria declined by 4.1%. For the same period, however, the company's smokeable products revenues only declined 1.6%. Meanwhile, the company's adjusted operating income jumped up 13.2%.
Branching out
While Philip Morris is managing to mitigate a declining number of cigarette sales with price increases, cigarette sales will eventually fall to a level where Philip Morris will get into trouble.
Nevertheless, Philip Morris has prepared for this eventuality and is working with Altria to diversify. Specifically, Philip Morris recently signed an agreement with Altria whereby the two companies will share the technology for electronic cigarettes, or e-cigs, and "reduced-risk" products under several licensing, supply, and cooperation agreements.
Reduced-risk products are, according to Philip Morris, products that reduce the risk of tobacco-related illnesses. The company recently invested €500 million in a reduced-risk product manufacturing facility in Italy ahead of a full commercialization of one of its reduced-risk products in the second half of 2014.
According to Philip Morris, once the factory is fully operational, its annual production capacity is expected to reach up to 30 billion units by 2016.
Meanwhile, Altria has been busy developing its own e-cig product for distribution within the U.S. The product has only been rolled out into a few test states, but a national rollout is planned over the next few quarters. So far, the product has been receiving a good response from customers.
Secure dividend
Perhaps the most attractive quality of Philip Morris is the company's dividend yield. Currently, Philip Morris offers a dividend yield of 4.7%; this is more than double the market average, and is quite attractive for many investors.
Since coming to market during 2008, Philip Morris' payout has edged up. It has risen from an initial payout of $1.84 per annum, per share during 2008, to $3.76 for 2013. That's a compounded annual growth rate of just under 20% and this is likely to continue.
While Philip Morris' payout has more than doubled during the past five years, it has only grown in-line with funds generated from operations. During the past five years, the company's payout ratio has for the most part remained below 60% of free cash flow.
Other opportunities
Still, if Philip Morris is not your cup of tea and you're still looking for a trustworthy dividend-paying company, McDonald's (MCD +0.75%) could be a great pick.
During the five-year period between 2008 and January 2014, McDonald's increased its dividend payout to investors by 116%. This growth is actually faster than Philip Morris' dividend growth over the same period. In addition, during the same five-year period, McDonald's has repurchased 21.4% of its outstanding shares. Figures from last year show that McDonald's returned $5 billion to investors during the year through both buybacks and dividends; this works out to around $5 per share.
Just like Philip Morris, McDonald's has plenty of capacity to increase its dividend payout during the next few years or even indefinitely if the company can continue to innovate. During the past five years, McDonald's has generated around $21 billion in free cash flow from operations. From this free cash flow, McDonald's has paid out around $13 billion in dividends to investors; that's only 62% of free cash flow. I should also mention that over the same period, the company's operating cash flow has expanded 22%.
As McDonald's cash flow continues to expand, the company's dividend payout should grow as well. Even if cash flows start to contract, the company has plenty of space for dividend growth.
