Philip Morris International (PM) is one out of three excellent tobacco companies, which include Altria (MO) and British American Tobacco (BTI) as well. Together, they represent an exposure of almost 3% of my portfolio, and together with international tobacco companies, I have a 3.8% exposure to tobacco overall. I’m perfectly content with increasing this to at least 4.5% overall.

In this article, I’ll show you why I consider Philip Morris to be one of the holdings I aim to increase going forward.

Philip Morris International (PMI) Vector Logo - (.SVG + .PNG) - SeekVectorLogo.Net

What does the company do?

Philip Morris International was part of Altria until a full spin-off in 2008 with the ambition to free the company from operating outside of American responsibilities, litigation, and legislative structures. The ambition here was growth in non-US and, particularly, emerging markets, with Altria focusing on USA. At the time, Altria shareholders were given PM shares, and PM was listed in London as well as on the NYSE.

state of the art head office ... - Philip Morris International Office Photo | Glassdoor

(Image Source)

Philip Morris does have its legal seat in NYC, but it does not operate in America. Instead, a subsidiary of the former parent company, Philip Morris USA, owns the brands here, but the operational headquarters are in Lausanne, in Switzerland.

Like most tobacco companies in today’s day and age, Philip Morris has switched seats from obfuscating tobacco harmfulness to essentially saying that it’s targeting a long-term transition to smoke-free products as a benefit to adult smokers, shareholders, and employees. While a spin-off, PM can trace its roots back to 1847 and London, which makes it one of the oldest tobacco companies in existence.

Marlboro is known primarily for a number of brands that have revenues over $1 billion each. These include:

  • Dji Sam Soe, which has been around for 107 years and is a brand of unfiltered tobacco/clove cigarettes, the best seller in Indonesia, one of the world’s largest countries.
  • L&M, which come in a wide variety of different styles and flavors.
  • Longbeach, one of the most popular cigarettes in Australia.
  • Marlboro, one of the oldest cigarette brands in the world at 116 years.

… and others.

(Source: Investor Presentation, Philip Morris international)

Like most tobacco companies currently, PM focuses on managing the industry-wide ongoing volume decline as well as it possibly can, while motivating people to shift to heatless tobacco alternatives provided by the company.

At a structural level, PM is divided into six operating segments, signifying geographical regions. These are:

  • European Union, covering all of EU, Switzerland, Norway, Iceland and UK.
  • Eastern Europe, including southeast Europe, Central Asia, Ukraine, Israel, and Russia.
  • The Middle East and Africa, including the entire African continent, Turkey, and the international duty-free business.
  • South & Southeast Asia, including Indonesia, the Philippines, and similar markets.
  • East Asia & Australia, covering Australia, Japan, South Korea, China, Malaysia, Singapore and Others.
  • Latin American & Canada, including the South American Continent, Central America, Mexico, the Caribbean, and Canada. This segment also includes transactions related to Altria due to the US distribution of PM’s products.

The company, therefore, has a geographical structure. PM products have a market-leading position as a #1 or #2 market position in many nations and are sold in over 180 markets. Marlboro as a brand represented 37% of total 2019 cigarette sales, with leading international brands being Bond Street, Chesterfield, L&M, Lark, and others.

(Source: Investor Presentation, Philip Morris International)

The company has a minimum of a 15% market share in around 95 markets, and in many of them, much more than 15%. Sales of company products are set up through either:

  • Direct B2B/distribution, with selling directly to retailers.
  • Distribution through independent distributors who also distribute other FMCGs.
  • Exclusive zonified distribution, where distributors have exclusive right to distribute PM products in a geography.
  • Distribution through national or regional wholesalers that, in turn, supply the retail trade.
  • E-commerce infrastructures where the consumer buys directly from PM.

An international structure and business such as PM has, as such, requires a variety of different distribution models.

The change in business can be best viewed by comparing the company’s revenues by product category, which are currently shifting at a massive scale.

(Source: FY19 10-K, Philip Morris International)

In terms of operating income, the company has the following geographical exposure as of FY19.

(Source: Data from FY19 10-K, Author’s calculations)

When we look at the variance in terms of combustible versus RRP (Reduced-Risk Products), we see, however, that Australia/East Asia and Europe have seen significant growth, while other areas are either extremely low in terms of market share, meaning that the adoption rate has been slower in areas like Middle East/Africa and other geographies.

The one trend we can see is that virtually all brands, with the exception of L&M and the local Dji Sam Soe, are seeing secular volume declines even on a YoY basis.

(Source: FY19 10-K, Philip Morris International)

The company’s solution to this decline is the IQOS platform, which has been growing at a massive rate (together with other, similar products)

(Source: Investor Presentation, Philip Morris International)

The company’s platform includes both heated actual tobacco products and nicotine-containing e-vapor products. Thus, PM covers the entire segment with its four different IQOS platform, all belonging to the same family.

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(Source: Investor Presentation, Philip Morris International)

The company isn’t just a market share leader, it’s a market share owner in many core geographies. Germany, Italy, Japan, Korea, and Russia all see a 65%+ market share for the company’s heated tobacco, with Germany, Italy, and Russia having a PM market share of above 97% (Germany 100%). The company has also managed to expand IQOS to many new geographies.

(Source: Investor Presentation, Philip Morris International)

The platform currently has 15 million users – and this can be considered to be just the beginning of a decades-long growth trajectory, as evidenced by a quarterly user growth of 500,000 in 2Q20 alone, in one region (EU).

The company is investing in storefronts, customer service, digital services, and sales in order to more effectively launch and transition users from combustible products to RRP.

(Source: Investor Presentation, Philip Morris International)

As a result of the RRP introduction, companies like PM have shifted their tone entirely. They now freely publish the well-known effects of smoking of cigarettes in their investment material, as a counterpoint to the smokeless/heated/RRP product families. The companies know fully well that the consumers who’ll want to continue smoking traditionally will do so, while they have the opportunity to capture both existing and new customers for the new platform.

(Source: Investor Presentation, Philip Morris International)

The FDA recently authorized the marketing of IQOS as a modified-risk tobacco product as well, with PM’s goal being simple – current smokers are to be transitioned away from a traditional tobacco consumption to IQOS, which the company also owns, and where margins and profits are similarly appealing, but which (I argue) has even better competitive strengths in terms of binding a customer to the company’s products or platforms.

So, Philip Morris International is a transitioning tobacco company with a portfolio of legacy tobacco products that occupy market-leading positions in the world’s markets. In addition, it is in the process of shifting consumers successfully to its IQOS platform. PM makes money through manufacturing, distributing, and selling these products, and it’s one of the largest companies when it comes to this.

How has the company been doing?

Now that we know what the company does and how it is structured, let’s look at how things have been going as of late and during COVID-19 overall.

While PM has been affected by the volatile operating environment, as have most all other companies out there, the company expects revenue growth of >5% in net revenues and >8% in adj. EPS to continue once these COVID-19-related headwinds disappear. When this happens, of course, remains to be seen.

The 2Q20 operating results, however, were supremely encouraging. Why?

  • RRP now accounts for 24% of company net revenues.
  • Industry volumes of shipments started to recover in June and July of 2020, with EU volumes recovering despite continued headwinds in Indonesia.
  • Margins in the company were strong, driven by RRP increases and IQOS growing more and more profitable as the company increases scale.
  • 1H20 net revenues were only down 50 bps YoY, with combustible tobacco pricing actually up 5.4%.
  • Adj. margins rose by 230 bps, with an adj. diluted EPS increase of 8% YoY.

In short, 2Q20 came in far better than the company actually expected. The EPS was expected to be around $1 to $1.1 – it’s $1.29. Currency impact was lower than expected, and net revenue drops were towards the low or middle end of the expectation. HTU delivered were up 24%, even if cigarette shipments were down 17.6% during 2Q20. However, the trends during a 1H20 comparison basis were even better, with HTU shipments up 33.4% and cigarettes “only” down 11.2%.

In short, things are recovering well.

(Source: Investor Presentation, Philip Morris International)

The fact that RRP’s have risen to encompass almost a quarter of the company’s revenues in less than 6 years shows how ready the market was for a shift such as this – and Philip Morris is spearheading the non-US portion of this shift.

On a regional basis, results vary quite a bit more. EU results are up YoY, but LATAM/Canada is down significantly, with the Middle East, Africa, and East Asia/Australia also showing slightly negative tendencies. Eastern Europe and South/Southeast Asia, in particular, are showing excellent revenue increases versus comparable periods in 2019, showcasing the current differences in COVID-19 dynamics and markets in different stages of recovery.

PM continues to be a company targeting emerging markets, with current volumes at a 72% emerging market classification, compared to a 56% exposure in 2008. In terms of FX, few companies have a wider currency exposure than does PM.

(Source: Investor Presentation, Philip Morris International)

Also, despite trends of up and down, combustible tobacco pricing continues to be fairly average over the last 12 years, with an average of 6.5% of net revenues on an LFL basis. The volume decline has actually slowed somewhat over recent years if we look at cigarettes and combustible products.

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(Source: Investor Presentation, Philip Morris International)

In the end, RRP products like IQOS have really only begun to realize their full potential. At a $477 billion global nicotine market per year, only 5% is currently represented by heated tobacco and e-vapor, representing significant growth potential. 95% is still traditional, combustible tobacco. For PM, IQOS systems have significantly higher unit margins as well, compared to e-vapor cartridges, and IQOS has the potential to provide significant returns for the initial investment costs.

Fundamentally, there’s very little wrong with Philip Morris. The company has an A-grade credit rating, which it seeks to maintain, and it has access to the tier 1 commercial paper market. Over $7.5 billion are available at stand-by revolvers, and the company has a net debt/adj. EBITDA ratio of lower than 2.0X as of FY19 (1.9X), with a net interest expense of $600 million/year, down from $1.1 billion in 2014. The company’s maturities are well-laddered and come in a variety of strong currencies…

(Source: Investor Presentation, Philip Morris International)

… and it has lowered its financing costs of total debt from 5.0% in 2010, to 2.5% in 2019. Philip Morris has, at the same time, increased the weighted average time to maturity from 7.0 years in 2010 to 10.2 years in 2019.

In short, the company is doing very well in terms of capital and fundamental safety. Philip Morris does have an LTM payout ratio in terms of EPS of 91%, which does push it down from a Class 1 rating in my system, and 94% in terms of LTM FCF. However, operating margins are above 35%, FCF margins at 25% or above, and the company sports an interest coverage ratio of 14.27X in LTM terms.

So, as to the question of how the company has been doing, the answer is that it has been handling the pandemic very well due to excellent preparation, good volume trends, and good fundamentals. While the payout ratio has become elevated, this will slowly trend down once things turn around.

Let’s look at where we find Philip Morris in terms of valuation.

What is the valuation?

(Source: F.A.S.T. Graphs)

Here is where things start to differ somewhat from typical tobacco companies. While others may see undervaluation, PM actually tends to trade somewhat above a fair value estimate of 15X, and even today trades at a weighted average of 15.3X. Current forecasts show an expected 2% dip in earnings for FY20, which seems realistic given the quarterly trends and industry declines for combustible products, but a combination of RRP growth and return to normal operations is then set to result in 11% EPS growth in 2021 and 7% in 2022.

Again, I view this as likely given the estimates and historical forecast accuracy. It’s certainly not perfect, but stands at 91% accuracy with a 10% margin of error on a 1-year basis, at least from FactSet analysis.

Still, assuming this historical premium as false is the scenario we want to use as a base when estimating where the company may go going forward. And trends, looking at things here, are positive.

(Source: F.A.S.T. Graphs)

Even when trading at no more than 15X to earnings, which is below both current and historical levels, annual returns would still beat where the market is expected to go, at nearly 13.25% per year. Assuming we go even lower, PM’s earnings would have to become negative for the company to trend toward negative returns, while also cutting the dividend. Even assuming a 2% EPS growth rate until 2023 with a corresponding valuation at 12.5X would provide investors with a 2% positive annual return. The short-/medium-term downside is extremely protected here as things go.

Starting to expect returns to normal valuations grants returns of 18-22% per year until 2023, based on current EPS growth trends. Normalizing 2020-2023 EPS of 4 years, even including the COVID-19 year, gives us a normalized EPS of 5.86, meaning the company currently trades at a 13.32X earnings multiple to a 4-year normalized EPS. If we expect the growth estimates to be realistic, the company now trades at an 11.5X earnings multiple to 2023E earnings. Given that the typical trading range for Philip Morris is closer to 17-19X, I put a conservative value target at a 15X-16X earnings multiple, which, based on the 4-year normalized EPS, gives us a target range of $87.9-93.76/share, that I’m currently willing to pay for the company’s current and future earnings.

This gives us an undervaluation range of 12.58-20.00%, which I view as quite excellent given the safeties and credit ratings involved here.

Bulls and Bears

brown cattle

(Source: Unsplash)

The bullish thesis for Philip Morris is one I view as very clear and, in relation to other more complex stocks, as quite simple. Based even on a conservative upside or flat trading trends over the coming years, the company is set to deliver good returns, if not alpha. In today’s overvalued stock markets, such opportunities should be treasured and cherished.

Philip Morris also comes with considerable downside protection and safeties, given its operating industries and the products it sells. COVID-19 has shown us that even a pandemic affecting the lungs will not stop people from using tobacco or nicotine to any significant degree – just look at the sales trends we’re seeing globally, where the company’s sales are an excellent proxy for this.

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Because of this, I view the bullish thesis on Philip Morris as more or less “writing itself”. You’re investing in humans continuing to do something we’ve done for 8,000 years. Only alcohol has a longer history. Even if the legislation goes up or down, if it becomes more or less difficult – man will always seek to use substances like tobacco.

That is why investing in market-leading tobacco companies is something not to be done only at your own investment peril. In my view, you’re consciously avoiding excellent profits. While I wouldn’t have more than a 5% portfolio exposure to tobacco overall, I do want that 4-5% – and PM is an excellent way to build more safely.

polar bear on snow covered ground during daytime

(Source: Unsplash)

PM bears are a rare breed, and I find the bearish thesis complex. There are two ways to approach it.

First, and perhaps the most relevant, are bears who view investing in tobacco stocks as a no-go due to the health risks associated with tobacco. Those who read my articles know that I’m a non-smoker – in fact, I’ve never smoked or tried a cigarette in my life – and this actually breaks a cardinal rule of investing – know and love the product. While I can’t say I love the product personally, as I don’t use it (and likely never will), I do know it, and I love it for how others use it. The company does come with this risk though, that it sells products it knows are dangerous to consumers and it will always have legislative scrutiny and challenges.

The second relevant bear approach is RRP-related risk. IQOS is one optional product – but it’s actually one of many. Competitors have alternatives, and bears might view alternatives as better options. While Philip Morris does have some of the most beloved tobacco brands, the question is whether they’ll be able to fully transition its market dominance in its emerging market segments, which after all represent a majority of the company’s incomes. Being able to dominate markets like Germany initially is only the first test. In order to replicate a non-combustible success story similar to its 100+ year success in cigarettes, PM needs to do so in all of its markets, and in many markets, it’s barely begun doing so.

PM bears would point to this as too much of a risk, combined with tobacco as a risk as a whole. Furthermore, going from cigarettes to a more tech-oriented solution like the IQOS opens up the potential for cheap knock-off copies for those that can’t afford the real thing – both in terms of the unit as well as the HEETS sticks or whatever products end up working on the market. This opens up new risks towards which PM might not have seen much exposure previously, similar to perfume markets, luxury good markets, etc.

Bears would use these arguments to stay away from PM.

Thesis

I, however, obviously represent a more bullish view on the stock. Philip Morris, out of the big three, is the company I view as the overall safest investment. It has better credit, excellent debt management, and an appealing market diversification, thanks to its EM focus. With IQOS, the company has one of the most appealing non-combustible brands in the world. While I have to take others’ word for how “great” the product is in itself, the company’s sales numbers and growth do speak for themselves.

All of it makes Philip Morris an appealing company to own – and the current valuation in relation to what the market expects out of the company makes any sort of potential downside limited enough to where I view a “Buy” as appealing.

Because of this, I establish my target range of $87.9-93.76/share, that I’m currently willing to pay for the company’s current and future earnings, and an undervaluation range of 12.58-20%.

Thank you for reading.

Stance

Due to an undervaluation seen to current and future earnings of 14-20%, Philip Morris International is a “Buy”.

Disclosure: I am/we are long MO, BTI, PM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment.

I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.



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