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Philip Morris: Go with the Cash Flow

February 07, 2014 | About:

Cesc

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Philip Morris (PM) stock has been in a downward trend for the last three months, in part because of concerns about its stagnant revenues, shrinking tobacco overall market (PM is forecasting a 6% to 7% decline in 2014) and regulatory pressures, and partially due to the recent sell-off that has taken place in worldwide markets.

PM reached its 52-week highs in April 2013, with a share price of $97; the share price has fallen by 25% to close to 52-week lows, and it’s changing hands at $77 to $78 per share.

However PM still got it. This is a Buffett-like business with a deep moat based on brand recognition, global footprint and economies of scale. PM obtains outstanding ROIC that enables them to generate gobs of FCF that is mostly redeployed to shareholders through dividends and buybacks.

Regulatory Issues Are a Concern

There’s a love-hate relationship between regulators and tobacco companies. Undoubtedly there are serious health care issues derived from smoking and regulators have been rather successful at discouraging consumers from this nasty habit.

So we have to figure out which would be the worst case scenario for tobacco companies; it’s hard for me to imagine a scenario where tobacco consumption is totally banned worldwide for the following reasons:

-Smoking is addictive. There are between 0.8 billion and 1 billion consumers around the world; if a total ban were put in place, lots of smokers would buy their cigraettes in the flourishing tobacco black market.

-If excise taxes would be raised to sky-high levels, tobacco traffickers would make a killing acting as arbitrageurs buying in low excise-taxes states or countries and selling in higher-taxed markets. That’s already happening, in fact, in the U.S., since excise taxes in the State of New York ($4.35 per pack) are much higher than those applied in Virginia ($0.30 per pack). Such disparity boosts illicit-trade benefits.

-Plain packaging is a measure already adopted in Australia, but this is a counter-productive measure since it makes it harder for tobacco companies to sell their brands and easier for consumers to switch from premium brands to the lowest-priced generic products that generate less revenues. Hence, lower taxes are paid to states.

-Illicit trade (contraband, counterfeit, illicit whites) already account for 10% of global tobacco sales, and it costs $50 billion in lost global government revenues.

Counterfeit is a serious concern for health authorities; manufacturers of “parallel” brands are placing a non-controlled product in the market which is potentially more harmful than known brand products.

So, a reasonable set of rules must be agreed between authorities and tobacco companies, a very restrictive scenario propels illicit trade, and that represents billions in lost government revenues and additional health care concerns. While that would enable criminal gangs with easy financing due to the fact that tobacco illicit trade is almost as profitable as drug smuggling, but the “risk” profile is lower from a legal point of view.

Unfair Competition or Pricing Power

Even considering rising excise taxes, Philip Morris (as most tobacco international manufacturers) holds very strong pricing power due to its ability to pass on price increases to consumers, especially in emerging markets where the growth profile is higher than developed markets (EU). Mew PM CEO, Mr. Andre Calanzopoulos, went into a detailed explanation about this at the Morgan Stanley Global Consumer Conference, held on Nov. 20, 2013:

“Over the last four years, we have generated favorable annual pricing variances averaging a little over $1.8 billion and are on track to surpass this in 2013 having already achieved a nine-month variance of $1.5 billion. We believe that an average $1.8 billion in annual pricing is sustainable. Let me explain why in general terms.$1.8 billion over our 2012 cigarette volume of 927 billion units translates into $1.94 per thousand cigarettes. Our average retail price is around $3.03 per pack and the average multiplier from our net manufacturing revenues to retail price is around 2.7. This implies that our target pricing variance requires an increase of some $0.10 per pack, or 3.5%, in our average retail selling price. This includes all currently levied excise taxes, VAT and trade margins.”

Yesterday, PM announced results for the last quarter and full-year 2013. The price variance reached $2.1 billion in operating income, which means a very strong support to PM’s income that offsets the negative impact of declining sales.

Philip Morris Has Taken Several Intiatives to Fund Future Growth

Reduced Risk products

Philip Morris is working on the development of a new set of offerings, known as “reduced risk tobacco products” that heat tobacco instead of burning it. PM’s heat tobacco platforms are named Platform 1 and Plaform 2 products. PM aims to offer its customers with what seems to be the closest experience to the traditional smoking ritual, under a lower health risk profile than burn smoking.

PM is setting up new facilities in Bologna, Italy, under a $0.5 billion investment plan for manufacturing reduced-risk tobacco products. The factory will come to full production by 2016, and PM expects to generate around $1 billion in additional operating profit in the upcoming years.

E-cigarrette Market

PM entered into an agreement with Altria Group in December 2013 for distributing its e-cigarette products outside the U.S. Alternatively, Altria will distribute PM’s reduced-risk tobacco platforms in the U.S.

Actually, while the global market for e-cigs is growing at a fast clip, worldwide sales are just sitting around 2 billion dollar, PM does not expect this new alliance to move the needle significantly, firstly because global market size and also because unlike traditional cigarettes, e-cigs have a much lower rate of replacement, resulting in less repetitive product buys. PM expects a more rapid adoption of reduced risk products than e-cigarettes in the future to come.

PM Has Completed Several Acquisitions in 2013

Medicago: in Sep 2013, PM increased its stake in this Canadian biopharm company and now holds 40% of ir, Medicago is a vaccine and protein developer that uses tobacco leaf in its manufacturing processes; PM is aim to distribute its products in Asia.

Philip Morris SA de CV Mexico (now 100% owned by PM), PM acquired in May 2013 20% of the remaining stake of its Mexican subsidiary in a transaction for 700 million; it’s kind of difficult to figure out PMM sales and operating profit because lack of specific information, PM holds a 70% share of approximately 7 billion dollar Mexican market, so PM is paying around 700 million for 1,4 billion usd in sales, so a Price to Sales of 2, seems an accretive acquisition and will allow PM to decrease costs associated with minority interest.

Arab Investors TA, PM acquired a 49% stake in Arab Investors for 625 million USD, this agreement implies securing an interest close to 25% in the Societe des Tabacs Algero Emiratle (a joint venture within Arab Investors-TA and the Algerian government), enabling PM to the second position in the 30 billion cigarette Algerian market. PM expects this acquisition to be accretive during 2014.

Megapolis, PM announced in dec 2013 a 20% equity stake in Megapolis for 750 million usd; Megapolis controls a hefty 70% of tobacco distribution in Russia which is the second largest tobacco market in the world after China, PM expects the acquisition to be accretive since 1st quarter of 2014.

PM Is in Love with Its Shareholders

Ongoing share repurchase program:

Since its spin-off from Altria in 2008, PM has repurchased 539 million shares through September 2013 at an average price of $60, that represents close to 26% of total outstanding shares; PM started in August 2012 a new 18 billion share repurchase program that must be completed in 2015. According to the third quarter earnings call, PM has $9 billion still available for buybacks.

According to the last update given last Feb. 7 about full-year results, PM will allocate $4 billion this year for buybacks. That means scaling back the amount of capital committed to buybacks due to a higher allocation in business development ($2 billion), the increase in capex and the negative impact of currency adjustments.

PM pays more than 100% of FCF after dividends to shareholders through share repurchases. Than means it incurs in debt, but actually debt as of September 2013 remains at a conservative level of 1.62 net debt to EBITDA ratio.

Philip Morris Pays You for Waiting

PM is a consistent dividend payer that increases its dividends year after year, with a targeted payout ratio of 65%. The board last September approved a 10.6% dividend increase, and now it’s stated at $3.76 per share. If the share price remains floating around $78 per share (I don’t think this is going to last forever), that represents a 4.8% dividend yield that will be growing over time. Since its spin-off, the dividend cumulative growth has been 104.3%, or about 15% per year. If this rate persists over time, PM is entitled to double shareholders' dividend income each five-year period.

$78-79 usd per Share - What a Deal

As value investing practitioners, we see a common share as an ownership certificate in a company; once the company has paid to debt holders and preferred shareholders, we are entitled to receive our share in the form of dividends, or indirectly via share repurchases or retained earnings for reinvesting purposes.

After last quarter's result, PM provided the following information for the whole previous year and the guidance for 2014.

2013 Full-Year Results and Valuation

Adjusted diluted EPS $5.40 ($5.74 excluding negative currency effects) versus $5.26 in 2012 (*)Free Cash Flow $8.93 billion ($9.35 billion excluding negative currency effects) versus $8.36 in 2012.

EBITDA: $14.7 billion versus $14.8 billion in 2012

2014 EPS guidance in a range of $5.02 / $5.12; (excluding significant negative currency effects of 0.71 per share)

Total diluted shares outstanding: 1,622 versus 1,692 in 2012

(*) according to the financial statements provided by PM on Feb. 7, 2014, EPS in 2013 were $5.26 versus $5.17 in 2012)

Financial data for the last three yearsis as per the following table:

PM

2013

2012

2011

Share Price

78

83,64

78,48

Outstanding shares

1622

1692

1762

Market cap

126516

141519

138282

Cash

2154

2893

2550

Debt

27678

22839

18545

EV

152040

161465

154277

Sales

80029

77393

76346

COGS and excise taxes

59222

56389

55927

Gross profit

20807

21004

20419

SGAA

7292

7141

7087

EBIT

13515

13863

13332

Interest exp

973

859

800

EBT

12542

13004

12532

Provision for taxes

3670

3833

3653

Equity income

22

17

10

Net Income

8850

9154

8869

Non controlling interest

274

354

288

Net earnings PM

8576

8800

8581

Earnings stock

-45

-48

-45

Net earnings for diluted EPS

8531

8752

8536

D&A

882

898

895

Non recurring expenses

309

83

EBITDA

14706

14844

14227

EBITDA per share

9,07

8,77

8,07

EBIT per share

8,33

8,19

7,57

EBT per share

7,73

7,69

7,11

EPS

5,26

5,17

4,84

Cash flow opts

10135

9421

10529

CAPEX

1200

1056

897

Free Cash Flow

8935

8365

9632

CFO per share

6,25

5,57

5,98

CAPEX per share

0,74

0,62

0,51

Free Cash Flow per share

5,51

4,94

5,47

PER

15

16

16

EV/EBITDA

10

11

11

EV/EBIT

11

12

12

EV/EBT

12

12

12

P/CF

12

15

13

P/FCF

14

17

14

EV/FCF

17

19

16

EPS in 2014 according to PM, excluding the negative headwinds from currency impact, should be around $5.70. PM has been trading close to S&P500 multiples. At a normalized P/E of 16, the share price would be around $90, which is 15% above today’s price. While we wait for the share price appreciation, we will obtain a dividend yielding close to 5% on a yearly basis.

PM is able to generate close to $10 billion in FCF per year. It buys back stock at a rate close to 5% per year. Adding up the dividend and even with stagnant revenues, expected EPS appreciation would be at a minimum threshold of 10% per year. While there’s not a huge margin of safety at today’s price, a 12%/15% compounded return is a feasible goal for shareholders.

Additionally PM shareholders can expect to boost their returns if lower-risk products strategy works as PM’s management expects.

Disclosure: Long PM. This post is not a buy recommendation. It may contain mistakes or inaccuracies.

About the author:

Cesc

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Rating: 3.9/5 (8 votes)

Comments

TFC
TFC - 2 months ago
Tom Russo (Trades, Portfolio) correctly pointed out earnings from deveoped markets is being invested in developing markets as Asia has been the fastest growing segment of PM. I sense a race against the rollout of lower risk products with non-profit money(Bloomberg) being employed to stem the possible increase of volume from non-adult smokers in Asia. (PM pointed out the 30% adoption rates of its Tier 1 products in an Asia test study). In the final analysis If one could indulge an addiction without the health consequences one has to assume most would try it and being a smoker myself if the taste can meet the hype it's a win/win.







Cesc
Cesc - 2 months ago

@TFC, Yes, I think that's some kind of call option for PM's shareholders, if these new reduced risk products are successful they will win big.

Thanks for reading and commenting,

Cesc

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