Philip Morris Reports In-Line 4Q; Shares Fairly Valued
Analyst Note by Philip Gorham 2 Feb 2017
No news was good news for Philip Morris International, as the company reported a fourth quarter that was broadly in line with our expectations on both a geographical and brand level. Earnings per share of $4.48 came in a couple of pennies below our forecast due to some below-the-EBIT-line items, and we are at the high end of management’s guidance for 2017. Even if we decrease our near-term assumptions slightly, the time value of money is likely to more than offset any impact on our $95 fair value estimate. The key takeaway from this report was Philip Morris’ very strong price/mix, which remains one of the best in class in consumer staples at a time when we believe pricing power is being pressured by changes in the consumer and retail environment. Such pricing power is evidence that Philip Morris’ wide economic moat remains intact.
Fourth-quarter organic growth of 9% was somewhat distorted by price increases in some Asian markets, but the full-year underlying growth rate of 4.4% tells a more accurate story of Philip Morris’ current performance. This compares favourably with many of the diversified consumer product companies, which are struggling with weakening price/mix in the absence of inflationary pressures. On the contrary, Philip Morris’ full-year pricing of 8% was highly impressive and above the 5% we estimate in the medium term. The firm is not hampered by private-label competition, and smokers in the premium segment tend to be fairly loyal to their favourite brands. Such strong pricing, along with another period of solid execution, contributed to 11% operating income growth, again at the high end of the peer group.
Investment Thesis by Philip Gorham
Philip Morris International is one of the strongest businesses in our consumer defensive coverage. The company generates industry-leading normalized operating margins in the low- to mid-40% range and boasts a wide economic moat, with strong brand loyalty and cost advantages at its core. As consumers begin the long-term migration to e-cigarettes, we believe Philip Morris is backing the right horse and will be able to transfer these competitive advantages to its e-cigarette portfolio.
Despite the hype over e-cigarettes, combustible tobacco products still represent essentially all of Philip Morris' revenue, and the core business is performing well on an underlying basis. In 2015, constant-currency earnings per share grew 18%, driven by a below-average volume decline of 1% and above-average pricing of around 5%. While tighter border controls in Europe undoubtedly led to lower illicit trade and temporarily boosted volumes, other growth drivers appear sustainable. We believe Philip Morris' pricing power is firmly intact, and we forecast similar mid-single-digit pricing in the medium term. The firm's core markets are a healthy mix of developed and emerging markets, and this diversification should provide protection in the event that price and tax increases stretch the affordability of cigarettes in some markets in the medium to long term.
The emergence of e-cigarettes is the single most disruptive force in the tobacco industry in decades, and we think Philip Morris is allocating capital in the right places to ensure it remains a leader in the category. The company is rolling out its iQOS heat-not-burn product into national markets this year, and we think its big bet is likely to pay off, particularly if the firm can go to market with reduced risk and reduced exposure claims. The early signs are positive, and sales in Japan have been fairly impressive. As a tobacco product, heat-not-burn most closely replicates the smoking experience, and should allow manufacturers to maintain their cost advantage (generated in the high volume procurement of leaf tobacco) and brand equity as smokers migrate to the category.
Economic Moat by Philip Gorham
Powerful intangible assets are at the core of Philip Morris International's wide economic moat. In addition, the company's platform of total tobacco products and e-cigarettes gives it economies of scope and scale that make it difficult for new entrants to gain the critical mass of volume necessary to compete. Finally, the addictive nature of tobacco products makes demand fairly price inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.
Tobacco brands' intellectual property has created a loyalty among tobacco users toward the brands they enjoy. Philip Morris has an impressive brand portfolio that is evenly balanced across price points. In spite of the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. In fact, it is the bans on advertising that help to keep market shares stable and new entrants out. Philip Morris' leading brands include Parliament, Virginia Slims, and Chesterfield, and the firm also offers the only truly global and highest-volume brand, Marlboro. The company is the largest cigarette manufacturer outside of China and is the only one of the largest four players (excluding China National Tobacco) to have increased its market share (by 30 basis points to 16%) since 2008.
The heat-not-burn category is likely to offer Philip Morris the opportunity to migrate smokers to its e-cigarette platform while maintaining its brand equity. In test markets to date, iQOS has been launched under the Marlboro and Parliament brand umbrellas. As a tobacco product, heat-not-burn is likely to be regulated as such, which should keep barriers to entry high, brand equity intact and market shares stable. As a result, Philip Morris will be in a strong position to lead the category.
Historical returns on invested capital lend support to our wide moat rating. Philip Morris has generated returns on invested capital (adjusted for excess cash) of around 40% since splitting from Altria in 2008, and even through the past two years of foreign-exchange headwinds, ROIC hovered just below 40%. We forecast returns to remain in that region over the next decade as Philip Morris continues to invest for long-term growth in e-cigarettes.
Valuation by Philip Gorham
After second-quarter earnings that were broadly in line with our expectations, our fair value estimate for Philip Morris International remains $95 per share, which implies a 2016 P/E multiple of 21 times, a 2016 EV/EBITDA multiple of 15 times, and a dividend yield of 4.5%. These multiples are at the high end of international tobacco manufacturers, reflecting Philip Morris' strong price/mix driven organic growth opportunities.
Our fair value estimate is based on three key valuation drivers: volume, pricing, and margins. We assume flat revenue growth in 2016, as fairly strong price/mix of 6% is offset by a low-single-digit volume decline and the unfavorable impact of the strong U.S. dollar. Thereafter, we forecast revenue growth of between 4% and 5%, driven entirely by pricing. Our 2016 EBIT margin forecast of 40.3% is in line with last year, with modest operating leverage being offset by incremental investment in iQOS. Beyond that, we forecast revenue growth and cost rationalization to lead to 300 basis points of margin expansion by 2023. Our estimate of peak margins of 43% are some 110 basis points below the historical peak.
Despite higher costs of borrowing in the later years in our forecast period, we model an average of 6% EPS growth, driven by earnings growth with some support from share buybacks in the outer years. Our 2016 EPS estimate of $4.47 per share is slightly to the low end of guidance.
Risk by Philip Gorham
Our uncertainty rating for Philip Morris International is low. Evidence from the recent economic volatility suggests that industry fundamentals--and, therefore, manufacturers' cash flows--remain stable. With pricing power intact, the greatest operational risks, in our view, are the risk of more widespread plain packaging measures in large markets and foreign-exchange risk.
Any investor owning tobacco stocks should have the stomach for fat-tail risk. Although the businesses are stable, the threat of government intervention through large excise tax increases, for example, is omnipresent. Litigation risk is substantially lower for the European players, as most countries do not have a class-action legal process. Nevertheless, we regard government and legal risks as low-probability events with high potential impacts that investors should be aware of.
In general, we believe government regulation does little to affect the economic moats or the cash flows of tobacco manufacturers, and in some cases, regulation actually limits competition, lowers cost, and strengthens pricing power. Plain packaging is different, however: We believe that it could facilitate trading down, which would erode pricing power and be detrimental to moats in the industry. Australia introduced plain packs in 2012, and the United Kingdom and Ireland followed suit in 2016. If plain packages are introduced in any other major EU market, this could be materially detrimental to the firm, given its positioning in premium categories.
Philip Morris' functional currency is the euro, but it reports in US dollars. It also has exposure to currencies too small to hedge in large amounts on the open market. Although it has something of a natural hedge, with about 26% of its costs in euros almost offsetting the 32% of its revenue that is denominated in euros, strength in the US dollar can have a significant and detrimental impact on Philip Morris' earnings.
Management by Philip Gorham
Our stewardship rating of Philip Morris is Standard. Since its separation from Altria, Philip Morris has delivered total returns in the top half of its peer group, driven by top-decile share repurchases and dividend growth in the consumer industry. We hold chairman and former CEO Louis Camilleri in high regard, since we believe he created significant value for shareholders by reshaping Altria from a consumer packaged goods conglomerate into two pure-play tobacco powerhouses. However, Camilleri stepped aside from the CEO position in May 2013, making way for former COO Andre Calantzopoulos. This followed the retirement of CFO Hermann Waldemer a year earlier, who was replaced by Jacek Olczak. Although foreign exchange has weighed on profitability and cash flow generation in the last three years, Philip Morris has a strong track record of double-digit annual returns to shareholders since its creation in 2008. After almost three years of the new regime, we think appropriate capital allocation decisions have been made. Share repurchases have been suspended, a decision that we think was prudent given the strength of the currency headwind. We prefer that free cash flow be allocated to increasing the dividend, a policy management has pursued despite the temporary inflation in the payout ratio. Share repurchases are likely to return when currency headwinds abate and the payout ratio returns to a normalized level in the mid-80% range.
Internally, we believe capital has been allocated effectively. The heat-not-burn category better matches smokers' preferences than the other e-cigarette categories, and we think this will lead to greater consumer adoption. Philip Morris' investment in iQOS, therefore, gives it early leadership of the category and sets the firm up well for long-term growth.