Many people have ethical concerns regarding investing in tobacco companies. Warren Buffett (Trades, Portfolio) is a famous example. I am not sure where I stand on the issue myself, as I am writing about this stock there are particulars about the industry that do not feel very good. At the same time, I do not want to make that choice for anyone and there is a lot of merit to an investment into Philip Morris International (PM, Financial). This tobacco giant is only second in scale to China National Tobacco, a state company, and dominates outside of China. Philip Morris has an impressive stable of brands, including: Marlboro, L&M, Philip Morris, Bond Street and Chesterfield among others. It sells its wares in over 180 markets. Between 2008 and 2014 the company invested over $2 billion in research and product development to come up with technology that reduces risk to consumers and are acceptable to adult smokers. The company currently has a reduced risk portfolio that includes different technology to adress different preferences of smokers. Two products heat rather than burn tobacco, and two e-vapor products that do not contain tobacco and are based on different technology. Philip Morris has registered over a 1,000 patents worldwide relating to thsee RRP platforms and another 2,000 pending applications on new RRP developments:
Source: Philip Morris International
At this point it is only a dream but I am rooting for the company to develop a product that is less hazardous to consumers. Not because of a financial motive, I (currently) have no financial stake in it myself, but because it would save so many lives.
In the U.S. and Western Europe the number of people with a smoking habit is on the decline, yet in selected emerging markets the number is still going up. In addition people are getting richer in emerging markets, which makes them trade up from local brands to the iconic Philip Morris brands. The decline in the number of smokers in both the U.S. and Western Europe will most likely continue but nicotine consumption is addictive and people who can quit easily already did. This is one of the characteristics of this investment I am not entirely comfortable with. Theoretically addiction is a huge competitive advantage as customer captivity is high. In practice it does not feel that great to profit of addiction.
An aspect of this business that I find fascinating is that the restrictions posed on the industry by various governments do not always hurt shareholders so much. For example when advertising is restricted this makes it extremely hard for upstarts or new incumbents to take market share from Philip Morris with a fresh campaign or by calling attention to its new innovative product. There is a downside to it too(more on that later) but government regulation is not all bad from a shareholder perspective.
Financial strength
Philip Morris has about $30 billion in debt while TTM EBITDA totaled $13 billion. Current EBITDA is on the low side of the company’s average over the past five years. As smoking is not very sensitive to economic conditions, the debt load should be easily manageable. The company meanwhile keeps little cash on the balance sheet as it is returning this to shareholders quite efficiently through dividends and buybacks.
Risks
Legislators pose a risk to the company to some extent, a risk that is also often pointed out with gambling companies but is not entirely convincing. In the intro I have alluded to the benefit of regulation that keeps competition down. Governments also have a lot to gain by keeping the industry alive. The huge tariffs they put on tobacco, or gambling, fill up the government's coffers and make it easier for officials to get re-elected as they can spend the money on positive policies. Taking away advertising power or enforcing plain packaging (white packs) are powerful limitations that are sometimes imposed though. Whether these work to encourage people to quit smoking, or help them stay away from it, I am not sure, but I am sure it does not help the premium brands of Philip Morris. It keeps new competition out but when the customer is chosing between Philip Morris or another existing but cheaper brand, the package helps Philip Morris.
Management
Management is returning a ton of capital to shareholders through dividends and buybacks. That is something I like to see. Meanwhile it keeps a conservative debt profile and invests into R&D to make smoking less hazardous. Together board members and executives own $300 million worth of shares which is about 6x what the executive team made in total compensation in 2014. That means insiders are aligned with outside shareholders. Given quite a few shares are in the hands of board members I would love to see the executive team increase the number of shares it owns.
Valuation
The stock is quite attractive to me at current levels and I am in good company as Thomas Russo, of Gardner Russo and Gardner, thinks so as well. He recently added to this stake which now is up to 6,84% of their invested long portfolio. Another interesting buyer is Sergio Marchionne, who is a director and CEO of Fiat Chrysler Automobiles, who acquired shares at around $86 end of last year. I have written about this star CEO before on GuruFocus. He is widely respected for his ability to create shareholder value. He could also choose to invest his money in Fiat Chrysler Automobiles where he has more control. For me his investment is an important positive.
Because it is so hard to quit, some currency fluctuations left aside, the cash flow from Philip Morris is quite predictable. Because of that I like to look at its valuations through a Discounted-Cash-Flow lens. A simple DCF model with inputs of $5 in FCF per share, Cash Flow Growth of 8% (PM’s 10 year average) levelling off to a terminal growth rate of 3% projected 10 years into the future and benchmarked against the 11% return that can be expected from the S&P 500 it puts the net present value of a share of PM at $92. I regularly find stocks that are discounted more than 13% but given this is such a stable, reliable and well-known business, the discount is attractive.
Outlook
You could easily make the case tobacco is a dying industry. Yet, dying industries can be hugely profitable to shareholders. There is little motivation for new competitors to go after market share and even if there was legislators are making this a tough proposition. Competitors in dying industries also tend to behave rationally which helps to keep pricing up. The tobacco era may be ending (unless a solution to the health problems caused can be found) but there is some good money to be made in what probably are the industry’s final decades. Another interesting possiblity is further privatizations in China. China National Tobacco completely dominates the Chinese market. This makes it the top global player in Tobacco. As this is a state owned company that is responsible for 7% of the Chinese State’s revenue each year it is unlikely the state will move agressively to stop smoking. Meanwhile, if the company is privatized and the market opens up a little more, Philip Morris International could make some inroads there. In summary the company has interesting perspectives and is attractively valued.
