Philip Morris – Smoke-Free Product Replacement and Long-Term Investment Mandate

Philip Morris International Inc. (PMI) is an international tobacco company. The company is a holding company that is engaged in the manufacture and sale of cigarettes, tobacco and nicotine-containing products. PMI segments include European Union (EU), Eastern Europe, Middles East & Africa (EEMA), Asia, and Latin America & Canada. The company’s products are sold in more than 180 markets, and in many of these markets, they hold leading market share positions.

PMI’s portfolio of international and local brands is led by Marlboro, which accounted for approximately 36% of the company’s total 2018 cigarette shipment volume. Its other international brands include Bond Street, Chesterfield, L&M, Lark and Philip Morris, which contributed approximately 40% of its cigarette shipment volume in 2018. PMI’s recent product developments, scientific assessments, and modern facilities help to present smoke-free products to meet adult consumer preferences and regulatory requirements. The company aims to transform its products more smoke-free and ultimately replace cigarettes. The company was founded by Philip Morris in 1847 and is headquartered in New York, NY.

Overview

Philip Morris International dominates powerful brands in the tobacco industry. The company’s prominent benefits are established intangible assets and cost advantage among its competitors. Global revenue from cigarette sales, which approached USD 700 billion in 2016, will decline slightly by 2021, according to Euromonitor International. China, Indonesia, Russia, the US, and Japan are the world’s largest cigarette markets in terms of volume sold. Per-capita smoking rates are highest in Eastern Europe and the Asia/Pacific region. Government regulations have made the entrances almost impassable and kept their market share constant. Demand is driven by discretionary consumer spending and mitigated by awareness of the health effects of smoking. The profitability of individual companies depends on effective marketing. Consumers are particularly loyal in the premium price segment, which Philip Morris International dominates.

There has been a global decline in tobacco consumption that, if continued, will negatively impact the tobacco industry’s profits. This decline led the industry to invent and market new products, including heated tobacco products. Heated tobaccos are an extension of the industry’s strategies to undermine the government’s tobacco regulatory efforts as they are being promoted as part of the solution for tobacco addiction issues. In December 2014, the company became the first mover to make a large-scale launch of heated tobacco, commercializing IQOS.

Philip Morris International constructed a USD 120 million production facility in Switzerland and announced, in June 2017 the building of a USD 320 million facility in Germany focused on the development and production of heated tobacco products. The company announced plans to double production capacity from 50 billion disposable tobacco sticks (heatsticks) in 2017 to 100 billion sticks in 2018. In Japan, IQOS quickly gained market share, reaching 10% of the tobacco market in less than 1 year. A 2017 Reuters investigation found that before launching IQOS in a country, PMI engaged with high-level government officials in attempts to convince regulators that IQOS had health benefits and therefore should not be subject to the same regulatory restrictions as cigarettes, including marketing, labeling, and taxation. Heatsticks profitability is heavily dependent on the future of high-level taxation concerns. 

Per-capita smoking rates are highest in Eastern Europe and the Asia/Pacific region. Government regulations have made the entrances almost impassable and kept their market share constant. Consumers are particularly loyal in the premium price segment, which Philip Morris International dominates.

Investment Characteristics

PMI IQOS 052019
Source: PMI website

The company’s shipment volume growth increased by 1.1% in the first-quarter of 2019. The volume increase is a result of higher heated tobacco product shipments and favorable pricing for combustible tobacco portfolio. However, increased regulatory cigarette price increases, additional excise taxes overseas, and a strong dollar against emerging market currencies affect pricing negatively, which declines 4%. Previous corresponding period (PCP) volume decline is %1.5 to 2%. The year-on-year volume decline is 25% to 50% better than industry volume decline; it represents that consumers have brand loyalty over their competitors. Philip Morris has a consistent and relatively high gross margin (typical for the tobacco industry) of 64%.

EPS (earnings per share) growth has consistently exceeded increase in RPS (revenue per share) annually; however, for Q1 2019, the financial metrics are looking differently. Sequential EPS growth (Q1 2019 vs. Q4 2018) was down 29.3%. PCP EPS growth (Q1 2019 vs. Q1 2018) was down 13%. Sequential increase in revenue per share (Q1 2019 vs. Q4 2018) was down 9.9%. PCP growth in revenue per share (Q1 2019 vs. Q1 2018) was down 2.1%.

The company has increased its dividend for the last ten years, with an annual increase rate of 8.03%. The dividend yield of 5.4% is 2.13 times the US 10-year bond yield of 2.53%. This is above the benchmark of 0.67 set by Benjamin Graham. The average annual compound return on the share price in the last 5 years was 10.3%, exceeding the average annual compound return on the S&P 500 Index of 9.5%. Philip Morris ranked as one of the lowest short-selling stocks in the NYSE Short-Selling market, which is a bullish indicator.

The trailing twelve months P/E of 16.7 is below its Cyclically Adjusted Price Earnings of 17.3, which is also below its historical average of 20.7 over the last 2 years. However, the sector average of P/E is 15.5.

The year-on-year volume decline is 25% to 50% better than industry volume decline; it represents that consumers have brand loyalty over their competitors. Philip Morris has a consistent and relatively high gross margin (typical for the tobacco industry) of 64%. The company has increased its dividend for the last ten years, with an annual increase rate of 8.03%. The dividend yield of 5.4% is 2.13 times the US 10-year bond yield of 2.53%.

Valuation

Our fair value estimate for Philip Morris is USD 97 per share. We segmented the company as a classic consumer defensive due to strong brand loyalty. We classified the company in large-cap and value as a result of Philip Morris’s advanced position in heated tobacco and historic spot in traditional cigarettes. We estimate the company’s enterprise-value-to-EBIT ratio of 16.20. Also, an estimated enterprise-value-to-sales ratio is 6.12 in our analysis. After decades of high growth, cigarette consumption is declining following the implementation of strict regulations around the world. The company’s annual volume decline is only approximately half to two thirds the forecast industry volume decline; it indicates that many smokers are continuing to favor their brands over their competitors. Also, Philip Morris is the leading company of promoting heated tobacco as reduction of harm to traditional cigarettes. We believe that heated tobacco has the potential to abate consumer consumption weakening. IQOS production is accelerating with assumption relating to reduced-risk products in our valuation. Estimating heated tobacco products is advertised to current cigarette smokers; the volume trend would not convert substantially as smokers convert to heated tobacco. Therefore, we estimated the approximately 2% volume decline, similar to recent trends. However, strong brand loyalty and the company’s premium brands support its pricing power, consistent with the cigarette business and consumer defensive sector characteristics.

Risks to consider

The company’s year-over-year free cash flows represent a stable trend relative to economic fluctuations and litigation against the industry in Canada. Plain packaging legislations in large markets are the risk of the company’s operation, and application of these legislations is challenging to forecast. Tax regimes, including excise taxes, sales taxes, and import duties, can disproportionately affect the retail price of cigarettes versus other combustible tobacco products. The company’s premium-price cigarette category, tax regimes based on sales price can place Philip Morris at a competitive disadvantage in certain markets. Therefore, the company’s volume and profitability may be adversely affected by these markets. Damages claimed in some tobacco-related litigation are significant and, in certain cases in Brazil, Canada, Israel, and Nigeria, range into the billions of U.S. dollars. The company anticipates that new cases will continue to be filed.

Industry consolidation and privatizations of state-owned enterprises have led to an overall increase in competitive pressures. Some competitors have different profit and volume objectives, and some international competitors are susceptible to changes in different currency exchange rates. In certain markets, the company is dependent on governmental approvals of various actions such as price changes, and failure to obtain such approvals could impair the growth of our profitability.

The other major problem currently is a stronger dollar. Certain emerging market currencies are being hit even harder. The company has exposure to some emerging market currencies too small to hedge in the market.

The company’s premium-price cigarette category, tax regimes based on sales price can place Philip Morris at a competitive disadvantage in certain markets. Damages claimed in some tobacco-related litigation are significant and, in certain cases in Brazil, Canada, Israel, and Nigeria, range into the billions of U.S. dollars. In certain markets, the company is dependent on governmental approvals of various actions such as price changes, and failure to obtain such approvals could impair the growth of our profitability.

Other considerations

The management’s investments of alternative and conventional areas have been admirable, and its long-term growth confirms its success. The management’s share repurchases totaled to approximately USD 35 billion, and some investors believe that these buybacks are aggressive, and reduce its dividend payments. However, the company sustains long-term value for shareholders and supports earnings growth with these repurchases.

The non-smoker CEO, Andre Calantzopoulos, has mentioned the alternative solutions of cigarette and predicted smoke-free future. He stresses the technologic developments of smoke-free alternatives to cigarettes. The company invested more than USD 2 billion to heated tobacco plant in Italy. The company’s early leadership in heated tobacco and sustainable long-term growth indicate the management’s value.

Conclusion

PMI Stock Movements 052019
Source: tradingview.com

IQOS sales are still an insignificant part of its business segments. Philip Morris has considerable growth potential with heated tobacco products, and the company needs to promote and find a solution to regulatory restrictions with these alternative products.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.

Image Source: PMI website

Share on facebook
Share on twitter
Share on linkedin
Share on email
Author

Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Important Information

The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.