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Philip Morris International (PM)

In September 2018 we reviewed Philip Morris International's disappointing performance, dividend safety, and long-term growth outlook. Read the analysis here.

Philip Morris International was spun off from Altria (MO) in 2008, with Altria serving the U.S. and Philip Morris owning the international rights to all of Altria’s most famous brands, including Marlboro, Merit, Parliament, Virginia Slims., L&M, Philip Morris, Bond Street, Chesterfield, Lark, Muratti, Next, and Red & White.

Philip Morris markets its cigarette brands to more than 150 million customers in over 180 countries and has over 28% international market share (excluding China and the U.S.). While traditional tobacco products still generate the vast majority of the company's profits, reduced-risk products, or RRPs, now account for over 10% of sales and are growing rapidly. These products also carry higher margins because they have lower taxes compared to traditional cigarettes. 

Geographically, the European Union (30% of sales, 33% of income) and Asia (36% of sales, 33% of income) are the company's most important regions, followed by Eastern Europe, Middle East and Africa (24% of sales, 26% of income) and Latin American and Canada (10% of sales, 8% of income). 

Business Analysis

Philip Morris International is an absolute giant in the global tobacco world. The company is the market leader in seven of the 10 largest OECD countries (an organization of 34 international countries) by industry volume and is the second largest player in another two.

Outside of OECD countries, Philip Morris holds onto the number one market share spot in three of the 10 biggest countries by industry volume and is the number two player in another four.

The company’s dominance is driven by the strength of its brand portfolio. Philip Morris has six of the world’s top 15 cigarette brands, including the world’s number one brand – Marlboro.

As a result, the company enjoys excellent pricing power. Since 2008, Philip Morris’ annual average pricing gain has been 6%, excluding excise taxes.

Despite its strengths, Philip Morris International has run into some major growth headwinds in recent years, with sales and earnings grinding to a halt or even turning negative.

Part of this is due to lower cigarette volumes because smoking is an industry in secular decline. In fact, Philip Morris reported that its cigarette shipment volume was down more than 7% through the first nine months of 2017.

One of the reasons for the volume declines in recent years is higher government taxes in some of Philip Morris’ largest regions, such as the EU, Russia, and the Philippines (three of the company’s top four markets).

The EU implemented anti-smoking legislation in mid-2014, aiming to reduce tobacco consumption by 2% over the next five years, the equivalent of 2.4 million smokers. The EU has one of the highest excise tax rates on tobacco in the entire world, and roughly 70% of Philip Morris’ revenue from the region goes to the government.

In 2013, the Philippines raised excise taxes to boost the average price per cigarette pack by a whopping 48%. Annual excise taxes are expected to continue in the region, putting more profits in the government’s coffers at the expense of Philip Morris’ bottom line.

Russia initiated a new law in 2013 that banned smoking in many public places and restricted advertising. Excise taxes in Russia have more than tripled the cost of a pack of cigarettes since 2006.

Saudia Arabia is the latest example, having implemented a new excise tax in June 2017 that doubled the retail price of cigarettes. Philip Morris immediately saw its volume drop more than 40% in the region.

Overall, excise taxes have increased from 59.5% of Philip Morris’ revenue in 2012 to approximately 64% today, eroding its gross margin by more than 400 basis points. For comparison's sake, Altria’s excise taxes as a percentage of sales have actually declined over the last five years and sit near 24%, less than half of Philip Morris’ rate.

A somewhat more favorable outlook in the U.S., continued industry consolidation, and growth in reduced-risk products such as IQOS (more on that later) have led some investors to speculate that Altria and Philip Morris could merge.

While Philip Morris' operating margins have declined in recent years due to rising taxes unfavorable currency exchange rate fluctuations, and investments in RRPs, the company has managed to use aggressive cost cutting to lessen the blow. A lot of this success has to do with the industry's favorable qualities and Philip Morris’ wide moat, driven by the company’s excellent brands and pricing power.

In fact, Warren Buffett, commenting on the tobacco market, once remarked, “It costs a penny to make. Sell it for a dollar. It’s addictive. And there’s fantastic brand loyalty.”

These qualities help Philip Morris keep revenues stable and hopefully growing despite the ongoing cigarette volume pressure caused by rising global anti-smoking sentiment. 

Management is also working hard to insulate the company from the worst of the long-term decline in global smoking habits with its strong push into reduced-risk products.

Specifically, the company has invested more than $3 billion since 2008 into developing its IQOS heat stick (which doesn’t burn tobacco) and its MESH vaporizer technology (which creates a nicotine rich vapor with none of the carcinogenic chemicals found in tobacco).
The actual percentage of sales contributed by RRPs is growing quickly (13% of third-quarter 2017 net revenues, up from 4.9% at the start of the year) as IQOS continues seeing very strong growth in Japan (where it was initially tested) and other nations where it was more recently launched.
To-date, Philip Morris has launched IQOS in key cities in 31 markets, and more than 3.7 million adult consumers have already stopped smoking and switched to IQOS. IQOS volume trends are rising around the world, and Philip Morris is investing in additional manufacturing capacity to meet demand.

This is key to the company’s long-term future, and you can see that market share and distribution metrics are rising quickly in a number of major countries. IQOS uptake is likely benefiting from the product's lower taxes compared to cigarettes (remember the steep excise taxes), as well as more lenient marketing rules.
A big plus for Philip Morris is that if IQOS can indeed become the dominant brand of future smoking alternatives, then its world-class access to tobacco will give it large economies of scale (IQOS is a heated tobacco product, not an electronic cigarette). 

Even better, IQOS is a higher-margin product for the company since it is not (yet?) weighed down by the steep excise taxes placed on traditional cigarettes. As a result, the company could maintain its strong profitability and returns on shareholder capital for many years to come. Philip Morris' market share could also expand if heated tobacco products take off, helping the business continue growing even if the overall cigarette market continues seeing volumes decline.

It’s worth noting that the company submitted a product application for its IQOS product to the U.S. Food and Drug Administration at the end of 2016, which would open up a large market opportunity for Philip Morris (further fueling speculation of an Altria – Philip Morris reuniting). If approval is granted, Altria would sell IQOS in America, and Philip Morris would receive high-margin royalty payments from the sales Altria makes. 

Only time will tell whether or not Philip Morris’s customers will decide that “heat-not-burn” alternatives to traditional cigarettes are truly a fulfilling substitute, and more importantly whether they wish to continue using them or just use them as a tobacco cessation method. Future excise taxes, marketing restrictions, and regulations in general on RRPs are also a major uncertainty. 

However, the early traction is certainly encouraging as Philip Morris looks to gradually shift its business from being a manufacturer of combustible tobacco products to an RRP-focused company. 

Key Risks

There are three important risks to consider before investing in any tobacco stock, but Philip Morris in particular.

First, understand that the company has no exposure to the world’s largest smoking population, China (where 30% of global smokers reside).

While other developing economies like India are potential growth markets, the risk of governments becoming increasingly anti-tobacco due to rising global health costs is ever present.

In fact, in recent years, governments around the world have started to increasingly crack down on tobacco, including bans on marketing, steadily rising taxes that threaten to eventually price many people out of the market, and increasingly gruesome warning labels on packaging.
Source: VOX
Such warning labels, as well as an increasing regulatory pressure for “plain packaging” that limits branding, threatens the company’s brand equity and thus wide moat, as well as overall smoking rates.

Finally, while RRPs like IQOS represent a necessary adaptation to the future realities of declining smoking rates worldwide, keep in mind that regulators around the globe have remained largely hostile to these smoking alternatives.

In other words, while reduced-risk products may help to slow the decline in product volume, they may not be able to halt it entirely, and their high profitability could come under regulatory pressures. IQOS has been most successful in Asia, but raising awareness in other parts of the world could also be harder thanks to stricter limitations on marketing and consumer communications.

As a result, continued price increases and financial engineering (i.e. reducing share count over time) may become increasingly important components of tobacco companies’ long-term investment thesis.

That’s because in an industry facing secular decline, however gradual the decline might be, a falling share count is necessary to help maintain earnings and cash flow per share growth, the cornerstone of a safe and growing dividend.

However, Philip Morris International in particular has an issue of rising debt levels, as the company has taken on a lot of debt in recent years to fund its aggressive share repurchases.

In a rising interest rate environment, the company could have to slow its pace of buybacks, which would make earnings growth a bit harder to come by in the coming years.

If rising interest rates result in the U.S. dollar strengthening, growth headwinds could intensify as well since all of the company's sales and profits are denominated in international currencies and must be translated back to dollars for accounting purposes.

While currency fluctuations are unlikely to impact Philip Morris’ long-term earnings power, they can impact the stock over the short term.

Closing Thoughts on Philip Morris

If you are willing to overlook the secular decline of the overall tobacco industry and don't have moral misgivings about investing in an industry whose products ultimately harm its customers, Philip Morris International has the potential to be a decent high-yield dividend growth investment for a retirement portfolio. 

At the end of the day, the tobacco industry appears to remain an attractive area for investment for income-seeking dividend investors because of its stable cash flow, strong pricing power, and relatively slow pace of change, even despite growing regulatory pressures around the world. 

While many international markets have demonstrated greater volatility in recent years due to new legislation, currency movements, and more, there is still much to like about Philip Morris’ long-term prospects. Specifically, the company is seeing strong traction in its high-margin reduced-risk products, which could fuel market share gains and solid profit growth for many years to come.

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