Dividends are great. Whether your primary concern is growth or income, most shareholders appreciate the right to control their capital even if tax implications come with these payouts.

Few companies have raised dividend more consistently than Philip Morris International (PM). Today Philip Morris International has a 6% payout, and the company has raised the dividend every year since the split with its domestic peer, Altria (MO), in 2008.

Philip Morris International had a strong run over the last 10 years prior the stock plummeting after a concerning earnings report in June of last year, and shareholders had enjoyed steady income and strong total returns prior to the June disaster.

Data by YCharts

The company’s share price had more than doubled from 2010 to the middle of 2018, which is why the strong reaction to the company’s June earnings report in 2018 is so interesting. The reason shares plummeted after that earnings report was because the company reported that their IQOS technology had likely reached a saturation point in the company’s most important for this technology, Japan. IQOS is the name of the technology developed by Philip Morris International that heats rather than burns tobacco through a pipe like construct to deliver nicotine without transmitting the same harmful chemicals traditional cigarettes normally do.

Today I think Philip Morris’s shares are overvalued and the growth story of the company is largely dead since IQOS’s growth overseas is likely to be limited moving forward in the company’s two biggest markets, Europe and Japan. I also think since growth will likely be limited moving forward and the payout ratio is over 90%, future dividend increases will likely be muted.

Philip Morris International is expected to earn $5.14 a share this year, although management has guided below that number, and the company is expected to earn $5.55 next year. There are reasons to believe even management’s lower guidance is unrealistically optimistic. The recently released Nielsen data has suggested that the slowdown in global smoking rates has recently accelerated, and the dollar continues to rise as well. The company currently trades at nearly 14x next years likely earnings estimates of $5.55 a share, and those estimates are on the optimistic side.

Philip Morris’s shares plummeted in June of last year for two main reasons. First, the company’s earnings report showed a near complete halt to growth in Japan for the company’s IQOS technology. Second, the market reevaluated global growth prospects for IQOS as a whole since the Japanese market is the best international market for Philip Morris’s IQOS technology. Japan regulates vaping and e-liquids much more strictly, enabling IQOS to have a huge competitive advantage in Japan that the company does not enjoy in most major markets.

Since Philip Morris’s disappointing June earnings report last year the company has been forced to drop prices. Philip Morris’s market in Japan, by far the company’s most important market for heat but not burn products, and management recently reported a 6.7% drop in Heet Stick shipments in Japan just this last quarter. The reality is that IQOS’s growth appears to have already plateaued and hit a saturation point in the company’s best market, and the prospects for IQOS in Europe and other lower end markets is now much lower than what most analysts were projecting over the last several years.

Philip Morris’s core cigarette business has grown at around 9% a year annually at constant currency rates, but smoking rates continue to slow, and the company’s pricing power has limits. The euro remains weak against the dollar, and even though the euro isn’t likely to fall as much this year against the dollar as the 12% decline we saw last year, the U.S. economy remains much stronger than the economies in Europe and elsewhere. Philip Morris International also refuses to hedge currency fluctuation, and the company was only been able to grow earnings from $4.40 to $5.10 per share over the last 4 years. Many analysts are forecasting no earnings per share growth over the next year.

Future dividend growth will likely be limited as well. The company’s current payout ratio has been between 80% to 130% of earnings per share, and the dividend payout ratio has been consistently over 90%. As interest rates likely rise over the next several years, slowing growth will make maintaining and increasing the dividend even more difficult. The company’s rising debt levels, which are already over $25 billion, are likely why the share buyback program was cancelled as well.

Philip Morris International faces three main challenges moving forward. The company faces slowing smoking rates and continued currency headwinds as the dollar continues to rise against the euro and other major currencies. Management also must accept that they overestimated the likely impact of IQOS internationally, given the poor recent results in Japan. Philip Morris international was priced with a growth multiple before the dismal June earnings results last year, and the company’s high debt levels and extremely high payout ratio could make for dark future if smoking rates continue to fall in an already difficult operating environment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-06-19