Philip Morris sells cigarettes. It is one of the largest tobacco companies in the world that provides stable high dividend income with the least risk.
Tobacco companies are dismissed by investors because of the growing trend of Socially Responsible Investing. We do not often hear pitches about a tobacco company from famous investors on TV or in conferences due to its reputation risk. And it is not surprising that institutions like large pension funds and endowment funds shy away from tobacco stocks. Also it is well known that cigarette volumes have been declining for many years now and will probably continue the trend down in developed countries like WHO predicts. Moreover, any investments in tobacco industry would face litigation risks and regulatory uncertainties, just like the recent headlines about vaping issues all around the world: US, China and India.
It is however a good idea at this time to consider buying PM stock for below important facets:
1. It is a very stable business. People buy cigarettes in good times and bad times, even in a recession. It is pretty hard to quit because the additive nicotine in the tobacco products. Majority of the smokers attempting to quit are not successful as in most of the markets the smoking rate is only declining slowly (in low single digits annually). Due to the addictive nature of the products and customer loyalty to its iconic brands like Marlboro, demand for PMI’s products are very stable through economic cycles. For more information about market share and volume trends, investors can refer to PMI's detailed report here.
In the last 10 years, net revenue of PMI has been average about 29B USD and fluctuated within a 10% range. The volume of PMI sales has been declining, but since it enjoys considerable amount of pricing power again due to addictive products and customer loyalty, PMI has been able to successfully raise prices and improve product mix to offset the volume impact on revenue. Most of the fluctuations in annual revenue are due to foreign exchange rates as US dollar appreciates or depreciates against other currencies.
2. It has a first mover lead in Reduced Risk Products (RRPs) via heated tobacco platform iQOS. PMI is a leader in a tobacco industry transformation to create a smoke-free future and they believe the RRPs, while not risk-free, are a much better choice than continuing to smoke. IQOS are sophisticated electronics that heat specially designed heated tobacco units. While the idea of heating tobacco (instead of burning it) has been around for more than two decades, it took years of research and development to create a product that is satisfying to adult consumers. IQOS heats the tobacco just enough to release a flavorful nicotine-containing tobacco vapor but without burning the tobacco. Here’s the key point: the tobacco in a cigarette burns at temperatures in excess of 600°C, generating smoke that contains high levels of harmful chemicals. But IQOS heats tobacco to much lower temperatures, up to 350°C, without combustion, fire, ash, or smoke. The lower temperature heating releases the true taste of heated tobacco. Because the tobacco is heated and not burned, the company claims the levels of harmful chemicals are significantly reduced compared to cigarette smoke. The regulators including FDA will need to confirm whether these products are indeed reduced risk or not. In the meantime, iQOS is getting some early success in the markets that it has been launched. In East Asia markets, iQOS had a promising start and brought in over 3B USD sales of RRPs for PM in 2017. After it slowed down materially in 2018 in those markets, PM management put in more investments including new products launches and has been able to stabilize market share in the last couple of quarters.
IQOS also had early success in some EU and Eastern Europe markets, and management is put more investments behind it with 2020 in mind to push for a sustained success in adoption.
It is highly likely that it will develop into a razor blade business model, where iQOS devices be sold at very low margin but the heatsticks (HEETs) at very high margin (likely close to cigarettes). Of cause a lot more innovation is probably required for heated tobacco to replicate the smoking experience and to offset the decline in combustible volumes, but PMI is on the right track. Also keep in mind that iQOS is just one of the platforms that PMI is working on for RRPs. The management has done a good job in taking a very carefully measured approach for new products from concept to launch mostly through investing internally. They did not just go out and buy the hottest products on the market.
3. It enjoys superior ROIC with very low capital requirements. In the last 10 years ROIC (defined as EBIT/(NWC + NPA)) has been averaging 180% with the high of 220% and the low of 120%. That is high no matter what company you compare it to. It becomes even higher if excess cash is removed from the calculation. Normally people would say it is a great business for a company with 50% ROIC. 180% is insanely high! To put into context, from 2009 to 2018, PM generated 120B in operating profit with no increase of Net Working Capital and only about 1B USD increase in NPA to invest in RRPs in 2017. The business does not require high capital investments so it spins out cash to serve debt, pay dividends and buy back stocks.
4. The management has allocated capital intelligently. It is rare to find a management good at both business operations and capital allocations. Very often we see companies buy back shares in the open regardless whether it is undervalued or overvalued, and sometimes they buy back at peak earnings and valuation without cash reserves for a down cycle. That does not create but destroy value for shareholders. PMI has done it differently. They bought back shares aggressively after the split with Altria in 2008 when valuation was low and created value for shareholders. In more recent years they did not buy back shares at high prices but have been increasing dividends instead. With recent low valuation of the stock in the market, it presents an opportunity to create value for shareholders again via share repurchases and hopefully we will hear from management in the near future.
5. Tight government regulations over the years across the countries have created high barrier to entry for the tobacco industry. That in turn created a low competition environment for the industry, which is observable from relatively stable market share among big industry participants. It is almost unheard of that the large tobacco companies engage in price competition. PMI is probably the most skewed to premium brands like Marlboro among large companies. Cigarette brand loyalty tends to be higher in premium brands, which benefits PMI greatly. Comparing that to the erosion of brand loyalty in other consumer stables brands we have seen, it is night and day! PMI management would never need to worry about Costco or Walmart starts a private brand cigarette.
6. The stock recently sold off after the news that PMI and Altria are in talks regarding a potential all stock merger of equals. Management confirmed the talks but gave no details about the deal. There are two possible outcomes. If there is no deal, either because vaping regulatory risks related to Juul or whatever other reasons, the stock should bounce back to previous levels. If there is indeed a deal, we will need to see the terms but strategically it should benefit PMI in the long term. One benefit is iQOS adoption in the US. The merger would be the best way to align interests of both companies on that front. The combined company would be able to launch iQOS in the US more effective. Secondly, there is potential for cost synergies considering they were operating under one roof before and essentially sell the same products in different regions. The increased scale would create even more cost advantage also. There is also a benefit of currency hedge if the merger happens. All PMI’s net revenue is derived in foreign currencies but majority of its debt (about 20B) is in USD and some of its cost is also in USD. With a US distribution and USD cashflow, PMI would have a natural FX hedge.
7. The historically low valuation presents an opportunity to buy PM stock for stable income. It trades around 110B market cap with 24B long term debt. EBIT TTM yield is above 8% and EBIT 10y average yield is close to 9%. The dividend yield is about 6.5% with growing dividend amount. Compare all those to the recent 10yr notes PMI offered at 3.375% interest rate, the premium in investing the stock seems to provide large enough rewards for the risk.
Of cause with any investment there are risks. First is the regulatory risk with regards to iQOS. FDA will likely announce its opinion on the safety of iQOS products in the near future, particularly whether it reduces risks as compare to smoking. Should FDA's opinion be negative, iQOS adoption in the US as well as in the global markets would be greatly impacted. There is also a risk for PMI to overpay for Altria in the potential merger. The talks between the companies started a while ago before issues related vaping intensified. Now Juul may face great regulatory uncertainties, which should have an impact on its valuation. If PMI does not discount that in the valuation for merger with Altria, it would destroy shareholders' value and market price of PMI stock would likely decline. Lastly if the merger indeed happens, integration of large companies would add operational risks in the short term, and the market usually puts a discount to the valuation of combined company as compare to sum of parts valuation at first.
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