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Proinsias O'Mahony looks at the stock of Philip Morris International that has appeal to both defensive and growth-minded investors.

What's been the best-performing S&P 500 stock since the index was created in 1957? Some sizzling growth stock, a tech stock that hit the big time? Actually, with an annualised return of 20%, it's cigarette manufacturer Altria, proving that there's money to be made with a dividend-paying tobacco stock.  Declining sales in the US mean that Altria is no longer the growth play it once was. That mantle has been passed to Philip Morris International, the $90bn behemoth spun off from Altria in 2008.

Philip Morris now holds all of the non-US cigarette businesses once owned by Altria, with operations in 160 countries across the globe. That diversification helped it survive the global downturn, with euro zone weakness offset by strength in Korea, Indonesia, Turkey and various emerging markets, leading to the company recently unveiling a strong set of quarterly and full-year results. Fourth quarter earnings of $0.80 were more than 10% higher than the same quarter in 2008 and while net revenues for the year ($25bn) were slightly down, that was due to unfavourable currency movements. Excluding currency, net revenues increased by 7.5% in 2009. Furthermore, 2010 earnings of approximately $3.75-3.85 are expected, well up on 2009's $3.24.  Fourth quarter profits of over $1.5bn were reported and the firm remains in confident mood, announcing that it would repurchase $12bn in shares over the following three years. That confidence was confirmed by the 7.4% increase in its dividend (more of which anon).

Excluding the US, Philip Morris accounts for 16% of the global cigarette market and owns seven of the leading 15 international brands, with Marlboro being the most famous. 48% of sales come from the EU, with another 23% coming from Eastern Europe, the Middle East and Africa. 19% of sales come from Asia while the remaining 10% come from Latin America and Canada. 

Enthusiasts point not only to growth prospects in emerging markets but to the seeming absence of litigation risk. Morgan Stanley's David Adelman notes that, outside of the US, tobacco companies have never paid material health-related damages.

However, tougher international regulation is an obvious risk. Turkey, for example, where more than half the adult male population smokes, recently banned smoking in restaurants, bars and cafes. China, which accounts for more than one-quarter of the world's 1.3 billion smokers and where approximately 60% of adult males smoke, recently announced a ban on smoking in any indoor public space in seven provincial capitals. Japan, too, is clamping down. The fifth-biggest cigarette market in the world was long-regarded as an old-fashioned friend of big tobacco, given its low taxes and loose regulation, but that changed last year after it hiked prices by a third.

Price increases alone can reduce smoking demand by 2.5-5%, according to the World Health Organisation. However, population growth substantially reduces that impact.  Consumption in developing countries, where approximately 80% of the world's 1.3 billion smokers reside, is increasing by over 3% per year. Even if this trend is arrested, obvious opportunities exist. In developed countries, 35% of men smoke compared to 22% of women. In developing countries, those figures are 50% and 9% respectively.  In other words, women in developing countries represent an untapped market. As for China, despite the aforementioned restrictions, it remains a potential source of growth for Philip Morris which only entered the tightly controlled market in 2005. 

In terms of revenue and earnings growth, Philip Morris has comfortably outpaced other cigarette manufacturers like Altria over the last number of years. The absence of litigation risk and the likelihood of continued growth in tobacco consumption in developing markets mean that this is likely to continue in coming years. Of course, the problem with so-called growth stocks is that the market tends to build excessive expectations into the share price - unloved value stocks have traditionally beaten hyped-up growth stocks for that very reason. 

However, it trades at just 11.6 times 2010 consensus earnings. While that's a higher PE than Altria (9.7) and US giant Lorillard (11), it's not the kind of premium one might expect, given their differing growth prospects - in the five years prior to the spin-off of Philip Morris, revenues at Altria's international segment almost doubled from $28bn to $55bn while US sales revenues stagnated.  Indeed, the past year has seen a narrowing in the premium Philip Morris enjoyed over US tobacco companies whilst its PE is lower than that of British American Tobacco (12.4), its chief global competitor, as well as being substantially lower than the S&P 500.

There's also the hefty dividend (4.7%) on offer, almost double the dividend on offer from the S&P 500. It's not surprising that dividend payers have historically been the biggest stock-market winners, given that dividends have accounted for 41% of the total return of the S&P 500 since 1926, according to Standard & Poor's. Of course, companies slashed dividends last year, which proved to be the worst on record in terms of dividends for U.S. stocks. However, the security of PM's dividend is as attractive as its size - Altria has increased its dividend in 39 out of the last 41 years and Philip Morris's long-established management is equally committed in this regard. It has targeted a net earnings payout ratio of 65%, which looks eminently achievable given the free cash flow routinely generated by the company (over $6.5bn over the last year and an average of $5.4bn over the last five years).

As Credit Suisse analyst Thilo Wrede has noted, the outlook for growth in emerging markets is "improving" while pricing in developed markets "remains strong". The stock is reasonably priced, even if far from bargain basement territory. However, tobacco stocks have outperformed the overall market in 13 out of the last 15 years and a repeat performance is not unlikely, especially if a pricey-looking market comes under continued pressure in 2010. Exposure to developing markets coupled with stable revenues mean that the stock has appeal to both defensive and growth-minded investors. It's one to buy and hold, adding in times of weakness, whilst continuing to collect the dividend that has enriched shareholders in times gone by.

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