Light Up Your Portfolio With This Stock

Gaurav is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Philip Morris (NYSE: PM) is one of my favorite stocks in the US Consumer Staples universe, providing attractive growth prospects in addition to the defensive attributes typically ascribed to tobacco companies. Tobacco regulations in various countries have grown over time, with increased advertising bans and restrictions, indoor public smoking bans, warning labels on packages, graphic warning labels on packages and restrictions at the retail point of sale. However, despite all of the addition of new restrictions in various countries, global profit pool growth has remained more than 5% CAGR over the past 10, 15 and 20 years. Various packaging and advertising restrictions seem to have a minimal impact on volumes, which are most impacted by tax and price increases. When volumes fall on higher pricing, sales and margins are still able to grow, driven by better price realization.

Philip Morris is a safe stock to hold even during recession. During the 2008 economic downturn, Philip Morris experienced very limited losses (around 10-15%) and the shares bounced back to their pre 2008 slowdown levels by as early as the end of 2009 and have further traded up ~80% over the last three years. Going forward, I believe that there are ample growth opportunities for the company, led by disciplined pricing, emerging market strength, improving developed market trends and illicit trade reduction.

Philip Morris with a strong pricing potential and relatively low exposure to input cost inflation, provides a highly visible free cash flow growth. In a challenging economic backdrop, the company has consistently achieved its low double-digit EPS target and returned substantial cash to shareholders. The company has consistently raised its dividend over the last 5 years with most recent annual boosts of ~10% in 2012 and ~20% in 2011. Currently, the company’s forward dividend yield stands at 3.90% which is highly impressive in this world of low interest rates. Let’s compare Philip Morris’ dividend yield and payout ratio with respect to its peers like Altria Group (NYSE: MO) and Reynolds American (NYSE: RAI).

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>Philip Morris</p> </td> <td> <p>Altria Group</p> </td> <td> <p>Reynolds American</p> </td> </tr> <tr> <td> <p>Dividend Yield</p> </td> <td> <p>3.90%</p> </td> <td> <p>5.40%</p> </td> <td> <p>5.50%</p> </td> </tr> <tr> <td> <p>Payout Ratio</p> </td> <td> <p>63%</p> </td> <td> <p>92%</p> </td> <td> <p>87%</p> </td> </tr> </tbody> </table>

We can see that Altria Group and Reynolds American both offer an even more attractive yield profile. However, there is a catch. The higher dividend yield of these companies is merely a result of high payout ratio and thus, its sustainability is questionable. Philip Morris with its moderate payout ratio is more likely to keep paying the lucrative dividend amounts for the years to come. Going forward, Altria and Reynolds American have to rely on price increases and cost cutting due to declining cigarette consumption trends in the US. However, Philip Morris with its vast international presence and strong brand equity has a huge scope for growth in many international markets. I believe Asian countries like Indonesia, Philippines and China are the potential game changers and will drive tremendous long term growth.

Philip Morris is on the good side of analysts and has an expected annual growth of 10.63% over the next 5 years as compared to Altria’s 7.63% and Reynolds’ 6.87%. Taking into account the expected growth rates, Philip Morris seems to be the most undervalued tobacco stock in the market (trading at a PEG ratio of 1.56 as compared to Reynolds’ 2.08 and Altria’s 1.59). Thus, I see a solid upside potential in the stock and recommend buying it.

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