Will This 5.7% Yield Go Up in Smoke?

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Philip Morris (NYSE: PM) isn’t for everyone. Some investors don’t feel comfortable owning shares of a cigarette maker. But for those who do, one of the most attractive features about the stock is its 5.7% yield.

The company has raised its dividend in each of the past 11 years. That’s an impressive track record.

Philip Morris, which sells cigarettes outside the U.S., is transitioning to smoke-free products, though it will be a long time before people stop smoking.

And it needs to make the change. The company is currently losing market share to heated tobacco and vapor products.

That being said, things don’t exactly look dire for Philip Morris. Free cash flow is growing and is expected to rise again this year.

Though free cash flow was flat in 2016, it was up last year and is expected to climb again in 2018.

Dividend investors better hope the company meets those expectations.

Though cash flow is rising, it’s not growing enough to be in my comfort zone when it comes to the payout ratio.

I’m conservative. So I like a payout ratio of 75% or less. The payout ratio is the percentage of earnings or cash flow (I use cash flow) that is paid out in dividends.

If the payout ratio is 75% or less, that gives me confidence that even if free cash flow stalls or recedes, the company can continue to pay and even raise its dividend. If it’s higher than that, it’s like pushing the accelerator of a car close to the red line. You don’t want to get to the point where the dividend payout exceeds the amount of cash the company is generating. That’s not sustainable without using savings or borrowing money.

In 2017, the payout ratio was 89%. This year, in part due to a dividend raise in June, the payout ratio is expected to be 93%. That means it’s using nearly all of its free cash flow to pay the dividend, which is unusual in a company that is trying to completely transform its business. Shifting a business model costs money.

And if free cash flow dips to 2016 levels, it will not even generate enough free cash flow to afford its dividend.

All that being said, Philip Morris has been around a long time and has done a good job paying shareholders a strong and growing dividend yield. Management knows the dividend is important to investors. I don’t expect it to cut the dividend in the near future. But keep an eye on cash flow. It could become a problem in later years.

Dividend Safety Rating: B

If you have a stock whose dividend safety you’d like me to analyze, leave the ticker symbol in the comments section below.

Good investing,

Marc