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Why International Exposure Is the Key in the Tobacco Industry
Posted by: Patricio Kehoe (IP Logged)
Date: October 24, 2013 09:17AM

Industries that produce inelastic products, such as cigarettes, are highly lucrative. Yet, persistent anti-tobacco campaigns, government regulations, and tax increases are increasingly leading to a drop in cigarette demand, especially in mature markets. In order to face the challenges presented by a shifting scenario, Philip Morris International (PM) and Imperial Tobacco Group PLC (ITYBY) have opted for different strategies. By focusing on emerging markets, and offering alternative merchandise, these companies seek to offset declining sales in core markets.

Emerging Markets Growing Fast

Philip Morris is one of the most important players in the tobacco business, with over 29% of the non-U.S./non-China global market. With leading brands, such as Marlboro, L&M, Philip Morris, Chesterfield and Parliament, the tobacco giant has turned into a cash-generating machine. Having recognized the importance of international exposure, Philip Morris has diversified its revenue base by expanding to 180 countries.

Mature markets have seen demand for cigarettes dwindle, and anti-tobacco campaigns have contributed to reducing compound sales volume even further. Unlike Europe or the U.S., Asia and Africa offer tobacco companies great growth opportunities. Especially the emerging Asian economies represent a huge untapped customer base, which Philip Morris intends to capture. Growing populations, rising incomes and looser restrictions, have allowed the company to benefit from their strong market share positions. The firm’s largest recent success in Asia is the joint-venture with China National Tobacco, which will allow the cross-selling of products in China. This is a huge opportunity, since the Chinese cigarette market is largely a monopoly and cannot be entered with ease.

Although international exposure is one of the key elements behind Philip Morris’ continued growth, it is not the only factor to be considered. A global manufacturing and distribution system, along with economies of scale, have allowed the firm to generate industry-leading operating margins, and returns on invested capital. Also, by offering premium products, the company achieves margins, which commonly exceed the 40% mark.

In addition, as recent transactions by investment guru Joel Greenblatt have demonstrated, shares acquired can be sold off for a profit in the short term. Large holdings by Tweedy Brown on the other hand, give faith of Philip Morris’ long term return on invested capital. The annual dividend yield of 3.98%, backed by healthy cash flow levels, gives shareholders the opportunity to make lofty earnings. Nevertheless, Bears fear the 6% annual drop in European sales could have a negative impact, as the firm draws nearly 30% of its revenue from this region. Yet, bulls can be optimistic regarding Philip Morris’ future in light of the expansion of sales in emerging markets, and the highly addictive nature of its tobacco products.

European Market and Niche Brands

Imperial Tobacco sells more than 300 billion cigarettes a year in over 160 countries, making it the fifth-largest international tobacco company. In addition to cigarettes, the firm commands a leading position in the fine-cut tobacco, cigar and hand-rolling paper segments in several countries. Although the firm’s brands are not as globally recognized as Philip Morris’, it operates an array of niche brands with significant local appeal. As the European market becomes increasingly unattractive for tobacco firms, due to regulations and decline in demand, the company will seek to increase its foothold in emerging economies.

Reliance on the European market is the main risk for Imperial Tobacco’s long-term growth prospects, since 54% of tobacco revenue is generated in the old continent. With such a high degree of exposure to this mature market, the firm is vulnerable to the steady decline in sales the region has been experiencing. And sales volume is not expected to rebound anytime soon, as excise taxes are on the rise, smoking bans are extended continuously, and market regulations are becoming stiffer.

In order to counter the negative effects of declining sales in Europe, the company will seek to generate more revenue from emerging markets. Although the firm derives most of its volume from less-developed economies, only a third of revenue is obtained from these less-mature markets. Growing and less regulated markets, such as Morocco, where Imperial holds an 83% share, offer great opportunities.

Additional income is to be obtained from the expansion of the company’s product offerings. By entering the global cigar manufacturing industry in 2008, enabled by the purchase of Altadis, the firm now has a portfolio skewed towards high value products. The smokeless tobacco segment is also becoming lucrative, with the Skruf and Knox brands outperforming in Scandinavia.

Whether Imperial Tobacco will be able to continue growing in the face of European adversity remains unclear, yet I feel bearish regarding this stock. Heavy reliance on the recession-ridden European market, has already led to contracted operating margins below the 5% mark. Also, the firm is trading at an immense price premium of 101% relative to industry peers, which makes entry very risky considering future uncertainties. Since shares are overpriced, I feel bearish about this stock.

Philip Morris Is a Buy

Although exposed to different core markets, both firms have seen declining sales in mature economies. The U.S. and Europe have put higher taxes and stricter regulations in place, which have forced Philip Morris and Imperial to expand into emerging markets. However, Philip Morris’ brand strength, scale and early global expansion have given the American firm a competitive advantage which Imperial Tobacco lacks. Hence, I feel far more optimistic regarding Philip Morris’ future.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned.

Stocks Discussed: PM, ITYBY,
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