St. James Investment Company Updated: 21-Jan-14
PHILIP MORRIS (PM)
COMPANY DESCRIPTION
Philip Morris International is an American global cigarette and tobacco company, with products sold in over 200 countries with 15.6% of the international cigarette market outside the United States. Philip Morris International is the world's second-largest tobacco company, behind China National Tobacco, and holds almost 29% of the non-U.S./non-China global market. The firm owns seven of the leading fifteen international brands. Marlboro, the company's flagship brand, accounted for about one third of total volume in 2013. Other key brands include L&M, Philip Morris, Bond Street, Chesterfield, Parliament, and Lark.
Until a spin-off in March 2008, Philip Morris International (PMI) was an operating company of Altria Group. Altria explained that spinning off Philip Morris would leave the international company with more "freedom" outside the constraints of U.S. corporate ownership in terms of potential litigation and legislative restrictions to "pursue sales growth in emerging markets." The shareholders in Altria at the time were given shares in PMI, which was listed on the London Stock Exchange and other markets. Although the company is headquartered in New York City, it does not operate in the United States, with Philip Morris brands still owned by PMI's former owner Altria. The company’s operations are based in Lausanne, Switzerland.
INVESTMENT THESIS
Continued softness in several emerging markets and a strengthening U.S. dollar are weighing on the company’s 2014 revenue and earnings outlook. We believe these headwinds are cyclical rather than secular.
Philip Morris owns 150 distinct international and local brands, which it manufactures, markets, and distributes in more than 160 countries. The company produces 1,900 variations of its individual brands in sixty manufacturing facilities worldwide. Philip Morris brands are number one in eleven of the thirty largest markets by volume, and number two in another eight of the top thirty markets. Of the top fifteen brands in international markets, Philip Morris International owns seven of them. Marlboro is the company’s number one brand, and by far the number one brand in the world. Marlboro worldwide sales volumes are larger than its next three competitors' sales volumes combined.
In the United States, the one country where Philip Morris International does not operate, the cigarette industry will most likely keep shrinking by about 2%-3% a year for a long time. Outside the United States, where Philip Morris operates, the cigarette industry is growing, and some markets are expanding rapidly. Philip Morris' total 2012 cigarette volume of 927 billion units was 1.3% higher than its total 2011 volume. Last year, Philip Morris' total net revenues grew 1.5%, with operating income up 3.9%.
Philip Morris continues to generate an enormous amount of free cash flow, even though it pays out 60% of its revenues in excise taxes. The company pays out several billion dollars every year to shareholders via cash dividends and share repurchase. The current yield is 4.7%. Philip Morris is likely worth 25 times free cash flow or more to a private buyer. Yet Philip Morris is trading today for less than 15 times trailing free cash flow. We believe the company is worth $105 per share, 31% upside from its current price.
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St. James Investment Company Updated: 21-Jan-14
BUSINESS OVERVIEW
We believe that barriers to entry are very high in the tobacco industry and that stronger manufacturers like Philip Morris have established a sustainable competitive advantage. Low supplier and buyer power, high barriers to entry and limited availability of substitutes combine to make tobacco a very attractive industry. Philip Morris’ competitive advantages are reflected in the double-digit returns on invested capital generated on a consistent basis. In almost all of the company’s markets, pricing is rational and market share is stable.
Philip Morris holds the upper hand with suppliers as a result of fragmentation and the ending of price support. Each cigarette brand contains a unique blend of burley, flue-cured, and other tobacco types, and any divergence from the blend can affect taste and texture, so manufacturers must source tobacco leaf from consistent sources. However, there is very little differentiation among similar grades of tobacco, and manufacturers face a wide range of suppliers. Industry experts estimate that there are fewer than 50,000 farmers growing tobacco in the U.S., and a large number of farmers exist internationally. Some grades of tobacco are sourced in emerging markets such as Mozambique and Zimbabwe, where farming is highly fragmented. Additionally, tobacco leaf price support and quotas were abandoned in 2004, and by 2014, the market for leaf tobacco will be driven entirely by market forces, probably driving consolidation among farmers over the long term.
Smokers' dependence on cigarettes has created a fairly inelastic demand curve for the products. Nicotine is the addictive element added to cigarettes. According to the American Lung Association, about 70% of smokers want to quit, 50% try to do so, but just 7% succeed, and only about 3% to 4% quit cold turkey. Naturally, this leads to a fairly inelastic demand curve for tobacco products, suggesting that cigarettes are a key driver of average ticket at convenience stores and gas stations where approximately 68% of tobacco sales are made.
Despite inelastic pricing, consumers ultimately have the power to switch among brands. This acts as a ceiling on manufacturers' ability to raise prices. Brand loyalty varies. For example, Philip Morris’ management estimates that 90% of Marlboro smokers will smoke Marlboro even if an alternative brand is heavily discounted. We believe demand is more elastic for discount brands. Makers of discount brands (such as Reynolds American and deep-discount brands from the Vector Group) usually offer the lowest priced cigarettes at retail.
Marketing restrictions, liability payments, and large capital requirements all act as significant barriers to entry. With cigarette manufacturers no longer permitted to advertise in most developed markets, the ability to build a premium brand is now limited. As a result, market shares have been very stable over the past decade, as new entrants have been largely excluded and even existing players have found it difficult to increase share. Margins
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St. James Investment Company Updated: 21-Jan-14
on cigarettes remain attractive so there remains room to lower prices. With price being one of the few marketing levers to manipulate, competition is fierce among deep-discount cigarette makers and private-label brands.
Over recent years, smokeless products have expanded significantly from moist chewing tobacco to dry tobacco products that are consumed orally through a small pouch, and other dissolvable tobacco products. Gum and patches also help smokers kick the habit. As a result, such products can be regarded as substitutes. Some major tobacco firms are making moves into this adjacent category. E-cigarettes purport to replicate the physiological effects of tobacco consumption, and as such are a substitute. At present, e- cigarettes are growing at a very fast pace as smokers perceive them to be a safer alternative to cigarettes. However, over time it is likely that greater scrutiny will be placed on the safety claims of the products and that tax increases will close the price gap between cigarettes and their nontobacco substitutes. Internationally, Philip Morris International will be entering the e-cig market; Philip Morris International is taking a more structured approach by conducting clinical trials on three unique "next-generation platforms" that could be ready for full-scale production by 2016-17. Two of Philip Morris’ next-generation products heat tobacco rather than burn it, thereby delivering more nicotine than an e-cig and possibly offering a lower health risk than combustible cigarettes.
We find that the degree of rivalry in international markets is low. The leading four companies (excluding China) hold a combined market share of 78%. The international tobacco market is a highly concentrated industry. The oligopolistic characteristics play out in the marketplace in most international markets, particularly in developed countries, in the form of quite rational pricing. Despite headwinds from higher taxes, smoking bans, and tightening regulation, tobacco industry fundamentals remain strong.
There are still several headwinds in international markets. Australia's government has mandated plain packaging for cigarettes. This trend could cut into tobacco companies' profits as the black market could gain share. Additionally, other countries (including the United Kingdom) may opt to follow Australia's lead in the coming years. However, given increasing economic uncertainty, we expect Western Europe to continue to be a drag on growth in the short term. Additionally, excise tax increases in Russia and the proposed changes of the European Tobacco Directive could limit tobacco's growth in Europe over the next several years.
VALUATION
If you look at the global cigarette market, Marlboro is clearly the dominant brand. Altria owns Marlboro inside the United States but in 2009 spun off its international subsidiary Philip Morris International. Philip Morris International owns Marlboro outside the United States. In 2013, Marlboro made up about 35% of Philip Morris International's cigarette shipments. As an investor, Philip Morris International is an easy company to find attractive: Philip Morris owns 150 distinct international and local brands, which it manufactures, markets, and distributes in more than 160 countries. It produces 1,900 variants of its individual brands in 60 manufacturing facilities worldwide. The company’s brands hold the No. 1 or No. 2 position in many countries.
Over the last few years, Philip Morris consistently held at least 15.4% worldwide market share. If you exclude China, its global market share increases to almost 29%. Philip Morris has at least a 15% market share in over 90 countries, and much higher shares in many of them. Philip Morris brands are No. 1 in 11 of the 30 largest markets by volume, and No. 2 in another eight of the top 30 markets. Of the top fifteen brands in international markets, Philip Morris International owns seven of them. Aside from Marlboro, one should recognize
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St. James Investment Company Updated: 21-Jan-14
its other premium-priced brands: Merit, Parliament, and Virginia Slims. Philip Morris’ leading mid-price brands include L&M and Chesterfield. L&M has been around since 1952 and is now the fourth-largest cigarette brand in the world. Lower-price brands include Bond Street, Lark, Muratti, Next, Philip Morris, and Red & White.
These brands are all international brands, sold in many countries worldwide. They make up about 75% of Philip Morris shipment volume. The company also produces numerous local brands, many of which only sell in a single country. In the United States, the one country where Philip Morris International does not operate, the cigarette industry is shrinking and will likely keep shrinking by about 2%-3% a year for the foreseeable future. Outside the United States, where Philip Morris operates, we see a completely different story. The overall industry is growing with some markets expanding rapidly. As the leading international cigarette producer, Philip Morris benefits from that trend. Philip Morris’ 2012 cigarette volume totaled 927 billion units. International cigarette volumes were about 5.6 trillion units in 2012, 0.7% higher than 2011 shipments. The world outside the United States smoked more in 2009 than in 2008. And though cigarette consumption is declining in the European Union, it's growing in Asia, Latin America, Canada, and the EEMA region (Eastern Europe, Middle East, and Africa). Last year, shipments to Europe fell 6% due to consumption declines. However, shipments to other markets rose 4.3%.
Philip Morris earns consistently respectable profit margins and generates ample free cash flow, despite paying huge cigarette taxes. Gross profits before excise taxes exceed 80%, although excise taxes consume 60% of revenues. Cigarettes are taxed so heavily but yet the cigarette business remains a very good business, allowing Philip Morris to generate double-digit net profit margins. Philip Morris consistently earns 10% or higher net profit margins. In 2012, Philip Morris generated $8.3 billion of free cash flow. Before Philip Morris separated from Altria in March 2008, Altria was a consistent dividend payer. Since the spinoff, Philip Morris has increased its quarterly dividend annually, from $0.46 a share to $0.94 per share. The company pays out roughly half of its earnings per share in dividends, thereby leaving plenty of room for dividend growth as the business matures. In 2008, Philip Morris spent over $5.1 billion on share repurchases—today it spends more than $6.5 billion.
Net Earnings 6,038 7,150 6,552 7,498 8,879 9,154 Depreciation & Amortization 748 842 853 932 993 898 Deferred Income Tax provision (22) 5 129 101 15 (248) Asset impairment and exit costs, net of cash paid 301 (15) (27) (28) 11 26 Receivables, net (828) (25) (187) 123 (251) (398) Inventories (1,277) (914) 660 1,071 (36) (728) Accounts payable 47 (90) (116) (72) 199 10 Income Taxes 219 39 5 92 231 638 Accrued liabilities and other current assets 239 857 190 41 691 (183) Pension plan contributions (95) (262) (558) (433) (535) (207) Other 180 224 248 112 332 459 Net cash from operations 5,550 7,811 7,749 9,437 10,529 9,421
Capital Expenditures (1,072) (1,099) (715) (713) (897) (1,056) Free Cash Flow 4,478 6,712 7,034 8,724 9,632 8,365
Repurchase of common stock - (5,256) (5,625) (5,030) (5,372) (6,525) Dividends paid - (2,060) (4,327) (4,423) (4,788) (5,404)
Philip Morris remains the number one international cigarette company, far outpacing the competition, and the ex-U.S. market is growing. A dominant global consumer franchise like
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St. James Investment Company Updated: 21-Jan-14
Philip Morris is worth more than 20 times free cash flow, given the amount of free cash flow generated and the nature of the business and its continued dominance of a growing market. Although we can justify a price that values the company at 20 times free cash flow or more, Philip Morris International trades at roughly 15 times trailing free cash flow. Trading around $80 recently, we believe the company is worth $105 per share. In other words, we believe that there is large discount to our estimate of intrinsic value.
We doubt the global cigarette market will change very much in the next few years, except by growing slightly. During that time, we doubt Philip Morris International will change much, except by growing, paying higher dividends, and buying back larger quantities of its own stock. All of that should cause the market to recognize the stock's value. We believe that Philip Morris currently presents an ideal investment situation.
Forecast Terminal Assumptions 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Value Invested Capital Grow th -1.6% -1.6% -1.6% -1.6% -1.6% -1.3% -1.3% -1.3% -1.3% -1.3% Capital Charge 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% 9.1% Discount Rate 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% Net Operating Profit Grow th 5.6% 5.6% 5.6% 5.6% 5.6% 4.5% 4.5% 4.5% 4.5% 4.5% Cash Tax Rate 36.0% 36.0% 36.0% 36.0% 36.0% 36.0% 36.0% 36.0% 36.0% 36.0%
Net Operating Profit 10,594 11,189 11,816 12,479 13,179 13,918 14,543 15,195 15,877 16,589 17,334 Cash Taxes -2,382 -2,516 -2,657 -2,806 -2,963 -3,096 -3,235 -3,381 -3,532 -3,691 Net Operating Profit Less Tax 8,806 9,300 9,822 10,373 10,955 11,446 11,960 12,496 13,057 13,643
Invested Capital 19,450 19,132 18,820 18,513 18,210 17,913 17,679 17,448 17,220 16,995 16,773 ROIC 46.0% 49.4% 53.1% 57.0% 61.2% 64.7% 68.5% 72.6% 76.8% 81.3% Capital Charge -1,746 -1,717 -1,689 -1,662 -1,635 -1,613 -1,592 -1,571 -1,551 -1,531
Economic Profit 10,552 11,018 11,511 12,035 12,589 13,059 13,552 14,068 14,608 15,174 247,712 Discount Factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665 0.4241 0.3855 0.3855 Present Value 9,593 9,105 8,649 8,220 7,817 7,372 6,954 6,563 6,195 5,850 95,504
Sum of Present Value 76,318 44.7% Terminal Value 95,504 56.0% Invested Capital 19,450 11.4% Excess Cash 2,059 1.2% Total Debt, Leases & Obligations -22,715 -13.3% Total 170,615 100.0% Shares Outstanding 1,618.5 Estimate of Fair Value $ 105.41 Current Stock Price $ 81.00 Discount to Fair Value 23.2% Business Risk Low Required Margin of Safety 20.0% Entry Price $ 84.33
RISK TO INVESTMENT
Although Philip Morris has never lost a major tobacco-related lawsuit, there is no shortage of lawyers looking to get a large judgment or settlement out of the company. While we view this to be a low-probability event, tobacco investors should have the fortitude to handle some fat-tail risk. Additionally, legislation may have a negative impact on the company. If many governments drastically increase their tobacco excise tax rates, the company's production volume and profitability could suffer; should excise taxes rise too swiftly, the illicit trade could increase, thereby eroding some of Philip Morris' volume.
Some governments are considering following Australia's lead and implementing plain packaging for cigarettes. Plain packaging may encourage down-trading to value brands and bring about an increased prevalence of illicit cigarettes. Also, in 2012, European regulators passed a tobacco products directive that seeks to ban menthol and slim cigarettes. This directive will probably not fully ban menthol until almost 2020. Finally, the company generates revenue in a wide range of foreign currencies and reports in U.S. dollars; a strong dollar can adversely affect the firm's performance and make it more costly for PMI to repatriate cash with which to pay dividends and buy back shares.
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St. James Investment Company Updated: 21-Jan-14
ST. JAMES INVESTMENT COMPANY
We founded St. James Investment Company in 1999, managing wealth from our family and friends in the hamlet of St. James. We are privileged that our neighbors and friends have trusted us for over a decade to invest alongside our own capital.
The St. James Investment Company is an independent, fee-only, SEC- Registered Investment Advisory firm, providing customized portfolio management to individuals, retirement plans and private companies.
I M P O R T A N T D ISCLAIMER
Information contained herein has been obtained from sources believed reliable but is not necessarily complete and accuracy is not guaranteed. Any securities that are mentioned in this issue are not to be construed as investment or trading recommendations specifically for you. You must consult your advisor for investment or trading advice. The publisher of this report and one or more of its affiliated persons and entities may have positions in the securities or sectors recommended in this report and may therefore have a conflict of interest in making the recommendation herein. 4834-9369-8309, v. 1
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