Tobacco use causes millions of deaths every year. Investors who have no issues about owning such a company should take a close look at Philip Morris (PM) or Altria Group (MO). Although traditional cigarettes remain the most important product for these companies at the moment, tobacco companies are developing new and healthier ways to deliver nicotine to addicts.
Tobacco companies have always offered high dividends, and have been associated with strong balance sheets. Philip Morris, despite hailing from an unhealthy industry is poised to continue raising its safely maintained dividends. The company will find plenty of tobacco huffers in the developing world, if it can build out its international presence. Below is some insight into the company.
Performance Report Card
Philip Morris' strong brands give it tremendous pricing power. Before subtracting excise taxes, Philip Morris generated a whopping 87% gross margin in 2012. This is a testament to the company's incredible product economics. Its premium brands, like Marlboro and Parliament, allow it to charge high prices in markets around the world.
2013 has been a solid year for Altria. Altria has gained 28% matching the broader market. Altria has provided the consistent dividend growth that investors have come to expect. A 9% boost this year improved on its growth rate from previous years. It has increased its dividend for the last 44 years. The dividend growth rate was about 11.4% for the last decade. Philip Morris derives close to 30% of its revenue from the European Union, where excise taxes often make up more than 60% of the price of a cigarette.
The stock's market capitalization is about $130 billion, so it trades at a 6.8% free cash flow yield ($8.8 billion divided by $130 billion). Philip Morris uses most of its free cash flow to pay dividends and repurchase stock -- so most of the free cash flow it generates goes right back to shareholders. If Philip Morris can continue to generate its current level of free cash flow, investors would get an outstanding return from a large and stable company.
Growth Opportunities in Developing Nations
Philip Morris also has growth opportunities in developing nations, where taxes are much lower than in the European Union. For instance, most parts of Asia, Africa, and South America have lower excise taxes than the United States. Moreover, the company is developing reduced-risk products that may eventually surpass sales of traditional cigarettes in developed nations. If all goes according to plan, Philip Morris will be able to offset volume declines in developed nations with reduced-risk products in developed nations and higher traditional cigarette sales in developing nations.
Are Hybrid Cigarettes On the Cards?
Philip Morris International's new “reduced risk product” is a hybrid, a black, cigarette-shaped tube with a battery and electronics. On one end is a miniature cigarette, a couple of inches long, paper filled with real tobacco. If it's successful, they'll be available in test markets later this year. These bets are worth watching in the tobacco industry.
Sweeping the Market With e-cigarettes
Shareholders may think that the shift away from traditional cigarettes is bad news for tobacco companies, but it could end up being a growth driver. The e-cigarette market is still tiny compared to the tobacco industry; worldwide, e-cigarette sales may have topped $3 billion in 2013, compared to $700 billion for tobacco products.
Philip Morris' new Italian factories will produce safer alternatives to traditional cigarettes that are closer to the real thing than e-cigarettes. The company's heat-not-burn products are similar to e-cigarettes except they heat up tobacco to manufacture the taste of a real cigarette. The new heated products will launch in 2015; if the gross margin matches that of e-cigarettes, Philip Morris will be the market leader in what could be the next big thing for the tobacco industry.
Philip Morris and Altria have combined forces by licensing alternative products to one another; Altria has the right to manufacture and distribute Philip Morris' heated products in the United States, and Philip Morris has the right to do the same with Altria's e-cigarettes everywhere outside the United States. The result is that both companies have a full slate of cigarette alternatives to offer to their respective markets.
For investors whose primary concern is compounding money at a high rate over time, Philip Morris is worth a closer look. This company may become an income investor's staple. It has been inculcating in shareholder-friendly policies, and is expected to provide value for investors. It has a record of healthy operating cash flows. The venture of the company into e-cigarettes will support growth in the near future.
Philip Morris is well-positioned in the U.S. tobacco space. They have the leading positions in the largest and most profitable tobacco product categories. And in each of these categories, it competes with premium brands that enjoy strong equity and higher margins than most of their competitors.
Cost-conscious consumers may stop smoking or downgrade to a value-priced brand during economic slumps, but most consume the same brands at the same, or slightly lower, level. Therefore, in my opinion, this tobacco stock will continue to provide increased returns to its valued investors, and I am quite long about this company.
Pre-split Altria was, by far, the best tobacco company in the world. It owned Marlboro, the best-selling cigarette on the planet, and had unmatched global breadth. After spinning off Philip Morris' international operations, Altria is now concentrated in the heavily regulated U.S. market. Although Marlboro is still the No. 1 cigarette in the U.S., smoking rates are quickly declining, and regulations tend to be tighter in developed countries. This is why Philip Morris International, which has operations in more than 180 markets and owns seven of the top 15 international cigarette brands, is a safer long-term investment than its old parent company.