My Best Stock Idea For 2015

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Jan 21, 2015
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I like to look at every single day as an opportunity. An opportunity to grow, learn, change, and become better. So you can only imagine what I think of the New Year and the 365 opportunities that lie therein. It’s just an incredible chance to change your future.

It’s also a chance to grow your wealth and income, which is something that most of us are highly interested in.

And it appears to me that there’s one stock right now that perhaps offers a better chance at that than most. I don’t ordinarily proclaim an idea as “best” or a stock that’s likely to outperform any others or the broader market over really any period of time, especially just one year. It’s simply not a game I wish to play – Mr. Market is far too fickle – and it’s certainly not necessary for long-term success as an investor. However, after a lot of interest over the last few weeks about my best idea for the year, I figured I’d just go ahead and write a post on my favorite stock right now, which I think should do well not only in 2015, but also for many years to come.

My best idea right now is Philip Morris International Inc. (PM, Financial).

Overview

Philip Morris International Inc. is the world’s largest publicly traded tobacco company, manufacturing and marketing a variety of tobacco products. Their products are sold in more than 180 countries, excluding the US.

They own seven of the world’s top 15 cigarette brands including Marlboro, the world’s #1 selling brand.

Their fiscal year 2013 revenue geographically broke down as follows: European Union, 35%; Eastern Europe, Middle East & Africa, 26%; Asia, 26%; and Latin America and Canada, 13%.

Fundamentals

Philip Morris was spun off from Altria Group Inc. (MO, Financial) in 2008, so the usual 10-year financial results I look at aren’t available here. Needless to say, however, that Philip Morris International has been in operation for a very long time and is a very established company.

I’m going to show what the company has been able to generate over the last five years, which should give us some idea as to what the may be able to produce over the foreseeable future.

Revenue increased from $25.035 billion in FY 2009 to $31.217 billion in FY 2013. That’s a compound annual growth rate of 2.48% over that time frame.

Earnings per share grew from $3.24 to $5.26 during this period, which is a CAGR of 5.53%. Both top-line and bottom-line growth have been hampered over the last couple fiscal years due to currency effects, as I’ll discuss a bit more below.

Growth has slowed down over the last two years as compared to the prior three over the preceding time frame, but this appears more due to currency effects more than underlying issues with the company.

S&P Capital IQ is predicting 9% compound annual growth in EPS over the next three years, citing continued share repurchases and possible volume growth and pricing expansion in emerging and developing markets.

As far as a dividend growth is concerned, PM offers a lot to like. They’ve increased their dividend every year they possibly could since being an independently traded company, with seven consecutive years of dividend raises under their belt.

The five-year dividend growth rate stands at 12%, though I’d expect dividend growth closer to 6% to 7% moving forward.

What’s perhaps most attractive about this stock right now is its yield, at 4.79%. That compares extremely favorably to PM’s five-year average yield of 4.1%. It also compares very well to the broader market and most other stocks as well. It’s not often you find a stock that offers a yield of near 5% with a historical dividend growth rate in the low double digits. The total return prospects are obviously attractive.

The payout ratio of 80% is moderately high right now, though most tobacco companies routinely sport high payout ratios. Free cash flow comfortably covers the dividend right now.

Of particular note, the company has noted that it plans on returning around 100% of its free cash flow to shareholders in the future. And it just so happens that Philip Morris generates gobs of FCF because its operating cash flow is quite high and capital expenditures as a percentage of that cash flow is quite low. So you basically have a company that’s mature and operating at a high level interested in returning all of its FCF to shareholders. That, in my view, is called a “cash cow”.

The return will occur through increasing dividends and share repurchases, both of which PM is generous with. Just over the last five years, the company has repurchased some 300 million shares, reducing the share count down to approximately 1.6 billion.

PM’s balance sheet might confuse some, since the company sports a negative book value due to an unusually large amount of treasury stock. The company, like many others I can think over the last few years, has taken on low-interest long-term debt to help fuel buybacks. While PM now has over $25 billion in long-term debt on the balance sheet, its interest coverage ratio, at ~12, is more than satisfactory.

Meanwhile, the company’s profitability is off the charts. Net margin has averaged 27.03%over the last five years, which is outstanding. It’s also been steadily improving over the last five years.

Qualitative Aspects

The company boasts an estimated 28.3% share of the total international cigarette market, outside of the US and China. And as I mentioned earlier, they own the #1 brand in Marlboro. What’s particularly appealing is that its market share in a number of key markets has been growing as of late.

In my opinion, PM’s competitive advantages are strong and their economic moat is wide. Their primary product is addictive in nature, which creates enduring relationships with their customers. This addictive nature has also afforded the firm an ability to raise prices even in the face of increasing global excise taxes, which has effectively counteracted declines in global volumes.

In addition, the company has economies of scale and a distribution network that would be difficult or impossible for a new competitor to replicate. Limited competition in the industry keeps pricing favorable and advertising bans means it’s unlikely new competition will rise up.

Though volume declines have long been a concern in the industry, they are slowing. And the company is predicting just a 1% to 2% annual decrease in volumes from 2015 to 2017, which would be a solid improvement over what we’ve seen over the last three years.

Electronic cigarettes, also known as e-cigs, present a unique and exciting opportunity for PM and other major tobacco companies. This is the growth product that I believe these companies (and their investors) have been looking for for years now. PM has taken this opportunity seriously by investing in its own products, called reduced-risk products (RRPs). These include a number of platforms which offer products ranging from heated tobacco products and electronic cigarettes. They’re also using their capital and position to purchase established players in the e-cig industry, such as Nicocigs, Ltd., which sported a 27% share of the UK e-cig market at the time of PM’s purchase of the company in the summer of 2014.

Many of the RRPs are still in the stages of development and commercialization, but this presents a rather large runway of growth, in my view.

It should also be noted that PM is the only major foreign cigarette company to have an official foothold in China through the licensing of their Marlboro brand in that country. Though this is a small part of the company, any loosening of regulation in China could have a huge impact on Philip Morris and its ability to grow.

I mentioned currency effects earlier, which is having a material impact on the company’s results. Unfavorable currency negatively affected FY 2013 EPS by a full $0.34. For FY 2014, that number is expected to be $0.72. However, I think currency effects tend to even out over the very long term, so this headwind could very well turn into a tailwind down the road. Currency-neutral results have been very attractive and the company will continue to do business in spite of these setbacks.

Overall, I think Philip Morris is an excellent position to continue profiting from international tobacco usage.

Risks

Of course, the company does have risks. I view the company’s primary risks as regulation, litigation, and taxes. However, this is nothing new and the company has been dealing with these headwinds for decades. Plain packaging is perhaps one of the biggest risks, if it were to spread into major markets beyond Australia. In addition, there is the aforementioned currency risk.

Valuation

PM’s stock can be purchased for a P/E ratio of 16.78 right now, which is more or less in line with their average over the last five years. But this is in the face of a stock market that is near all-time highs. In addition, their opportunities right now are, in my opinion, even greater than they were five years now.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 6% long-term growth rate. That rate is conservative and factors in some of the short-term issues with currency and RRP investment, as well as the moderately high payout ratio. It’s also in line with the most recent dividend increase. I think that it’s fair to assume that PM can grow the dividend at this rate over the long term, especially factoring in their historical growth and the company’s guidance moving forward. Any favorable currency rates will possibly boost this rate. The DDM analysis gives me a fair value of $106.00.

Conclusion

I believe PM is an undervalued, high-quality stock. The yield is very attractive and I believe PM’s desire to return all of its FCF will result in generous dividend growth and total returns moving forward. Their competitive position is enviable and they sell an addictive product, leading to an economic moat that is about as wide as it gets. New growth products via RRPs are now coming online, which could offer a huge opportunity. Even without these products, PM has been doing very well, so the additions could generate returns beyond what the company is forecasting.

It’s not really an interest of mine to list stocks that I think will outperform the market or any other stock over a certain time frame. It has nothing to do with my goals or ability to become financially independent at 40 years old. Furthermore, the stock market is a highly unpredictable beast and even great stocks can remain undervalued for lengthy periods of time or become unwanted when they should be desired. However, I’ve had a number of readers email me about my favorite stock for the year, and this is it. If someone were to twist my arm and demand me to name a stock I believe will outperform the market this year, it would be Philip Morris International. In fact, this is the stock I listed when I was asked to be a part of a friendly little competition.

If I didn’t already have 115 shares, I’d be buying as much PM as I could afford right now. Fortunately, I was able to load up at cheaper prices and now have a position that’s probably about as large as I’ll ever want/need.

One last note: We all know PM sells cigarettes. We all know this is a controversial business. If this is all you have to add to the conversation, you’re not really adding anything of value. Cigarettes are a perfectly legal product where adults of legal age can freely purchase and use these products. You don’t have to purchase PM’s products and you don’t have to buy their stock. It’s a wonderful world where most of us have freedom and choices available to us.

In the interest of looking at different perspectives, I’m going to share some other valuation opinions about PM’s stock:

Morningstar rates PM as a 4/5 star value, with a fair value estimate of $90.00.

S&P Capital IQ rates PM as a 3/5 star hold, with a fair value calculation of $82.30.

Full Disclosure: Long PM and MO.

What do you think of PM here? A solid value? Do you like their opportunities?

Thanks for reading.