Philip Morris International (from now on PMI) is probably one of the most “hated” companies on the planet. This black sheep is literally black-listed by all institutions bar a few brave vice funds, which means PMI and other tobacco stocks have a huge base of retail shareholders, just like myself. PMI is a sin stock, a topic I wrote about some weeks ago, and sin stocks have historically performed much better than the rest of the stock market. Is this likely to continue?
The obvious reason not to own PM is of course that it produces products that is proven to be a hazard to your health. The negative health effects have been well known since the 1960s, and smoking per capita has been falling continuously in the developed world since then. If you as an investor don’t want to invest in such a company that is of course a fair point. However, PMI is developing presumably healthier products which are gaining market share. Furthermore, tobacco is not an illegal product, banning it would lead to a huge black market, and regulators are well aware of that.
No doubt smoking is bad for you: I have never smoked, and never will. However, I understand it gives pleasure and relaxation, and I know several people who smoke about 1-2 times a week, without being “addicted”.
Why do I chose to invest in PMI despite the health effects? I chose to invest in PMI because I consider smoking a personal choice, even though it might be addictive. No one is forced to smoke, and everyone knows smoking is bad. Besides, I consider for example McDonalds, Coca-Cola or Pepsi-Cola as equally bad for your health as tobacco stocks, but they are not black-listed by most investors. Almost 40% of the US population has diabetes 2 or predibetes, and this is because of carbs, sugar and junk food, all a huge part of the profits for these three corporations. Their products are just as hazardous for your health as tobacco stocks, in my opinion. I don’t want to point any fingers or moralize, and prefer to leave adults to make their own choices in life.
Below you find my reasons why I’m long PM (in no ranked order):
Reason number one: A simple business model
PMI manufactures and markets tobacco products all over the world, except USA. In March 2008 Altria decided to spin-off Philip Morris International, at the time an operating unit of Altria (Altria is now just the US part and looks less appealing to me). The spin-off was explained by giving PM more freedom compared to the litigation threats which is typical and ingrained in the US culture. The business is simply to sell cigarettes and heatsticks globally. They turn a commodity (tobacco) and turn it into a branded premium-priced product.
PMI’s markets are divided like this, numbers for 2019:
|revenue||income||margin||products revenue||products revenue|
|EU||9 817||3 970||0.40||8 093||1 724|
|Eastern Europe||3 282||547||0.17||2 438||844|
|Middle East & Africa||4 042||1 684||0.42||3 721||321|
|South & Southeast Asia||5 094||2 163||0.42||5 094||0|
|East Asia & Australia||5 364||1 932||0.36||2 693||2 671|
|Latin America & Canada||2 206||235||0.11||2 179||27|
An estimated 1.1 billion people smoke about 5.7 trillion cigarettes per year, according to PMI. That is of course a lot, and because the margins are high the cigarette producers make a lot of money. In fact, their income has been so stable that the US tobacco companies performed the best as a group on the stock market over the last century, by far.
The countries with the highest cigarette consumption (not per capita) are ranked like this:
- South Korea
PM has solid brands (more later), loyal/addicted customer and tremendous pricing power:
Reason number two: Tremendous pricing power – inelastic price
A really good business has pricing power. Smoking per capita in the US has fallen from 50% in 1970 to about 15% today, and still the tobacco companies have managed to grow EPS. Prices have simply risen more to offset the declining smokers (coupled with population growth). For example, in 2019 PMI increased on average their cigarettes prices 7.7%, more than the corresponding drop in cigarette sales. I expect this trend to continue together with new products (more later), as there are few substitutes, other than ones they introduce themselves (IQOS).
The biggest risk is a huge rise in taxation, like we have seen in Australia, where cigarette prices have doubled in six years. At which price will smokers quit or look for alternatives/black market options?
Reason number three: The tobacco market is close to an oligopoly
The tobacco market is dominated by just a few players. British American Company, Philip Morris, Imperial Brands, Japan Tobacco and Altria are the biggest and control almost all of the brands. They exert a huge power both on markets and regulators. The management teams know how to deal with regulators, something new ones don’t (for example JUUL).
Because of the concentrated market and scrutiny from regulators/lawmakers/litigations, the barriers to entry are very high, which makes it very hard for smaller innovators to penetrate the market. The most likely way is to “disrupt” the market, like for example JUUL did (but so far JUUL and Altria have made a mess of their cooperation).
Reason number four: The legacy business model is not likely to be disrupted
It’s a slow business where very little has changed over the last 100 years. The business has not been disrupted, and smokers will be around for the foreseeable future. This allows management to focus on less goals and spend less on R&D/CAPEX. However, this might change a little in the future. The e-cigarette (more later) has changed the tobacco landscape, but still we can expect cigarettes to be around for a long time.
When disruption is slow it means management can adapt, which they have done:
Reason number five: Reduced-risk products (RRPs) – IQOS
In 2015/2016 PMI made the dramatic decision of creating a smoke free future and set a new course for the company by setting an aim of replacing cigarettes with smoke-free products as fast as possible. That vision might seem a bit counterintuitive, but Philip Morris has 400 scientists and engineers constantly developing less harmful alternatives to cigarettes. The vision is that one day these smoke-free products will replace cigarettes completely.
One of the products they have developed is IQOS. This is a heating device that does no combustion (no ash or smoke) and presumably is much less harmful (although this is debated – it goes without saying that humans are not given lungs to inhale chemicals). It’s a controlled heating device with a specially designed tobacco product that generates a flavorful nicotine-containing vapor and lasts just as long as an ordinary cigarette. IQOS was first introduced in Japan in 2014, and since then it has expanded to 53 markets across the world. I would say Philip Morris has done this transition extremely well so far, but the new business plan is of course a bit more complex than the old cigarette legacy business.
Such a kit as as above costs about 100 USD, and packs of heatsticks cost about the same as their corresponding cigarette brands. IQOS have so far not been scrutinized by regulators like e-cigarettes, the latter have presumably been involved in many deaths. Altria and JUUL are so far in trouble, while IQOS is pitched as a safer alternative to e-cigarettes (vaping), but it remains to be seen if this actually is correct, only history will be judge. The difference is that IQOS contains nicotine like ordinary cigarettes but they are not burned like cigarettes, but heated. E-cigarettes/vaping on the other hand does not contain tobacco at all but rather flavourings. Depending on the future health risks, IQOS could be a potential money maker – or end up like a troublemaker like JUUL for Altria. But even without IQOS PMI will be a good investment due to the legacy cigarette business. I think it’s reasonable to estimate that governments will tax RRP less than ordinary cigarettes, of course only if health effects are less detrimental. Hence, margins are more likely to stay high.
The margins for RRPs are higher than ordinary cigarettes. While RRP represented only 7.8% of the shipments in 2019, it contributed to 19% of net revenues (and 98% of R&D). These numbers demonstrate the significant and rapid shift in their business. An estimated 14.6 million people globally used IQOS in 1Q2020, up from 10.4 million one year ago. This shows the enormous potential for this product, albeit we can expect a high degree of “cannibalization” from ordinary smokers, estimated to 71% by PMI.
In 1Q2020 HTUs (heated tobacco units) accounted for 9,6% of all shipments, while its share of net revenue is 21.7%, up from 18.7% in 2019:
|HTUs % total of||RRP net revenue|
|shipment volume||share in %|
The decline of cigarettes, their legacy business, and the rise of their HTUs are summarized in this table:
|Cigarettes sold (units in millions)||HTU (units in millions)|
|2016||812 946||7 394|
|2017||761 926||36 226|
|2018||740 315||41 372|
|2019||706 709||59 652|
If you want to go into more detail about IQOS you can read more on this link.
Reason number six: High cashflow – most cash returned back to shareholders
On average 28% of the revenue ends up as free cashflow and CAPEX is a modest 3.5% of revenue. Gross margin is 65% and operating margin is 35%. PMI generates cash on the same level as for example Facebook and Google/Alphabet.
Because Philip Morris throws off a lot of cash, and litigation risk makes it risky to build capital, most of the profits are handed back to shareholders in dividends, less via buybacks, and currently the shareholder’s equity is negative. After the spin-off from Altria in 2008 PMI increased debt from 11 to 25 billion, with most of it spent on buybacks. Outstanding shares decreased from 2076 million in 2008 to 1549 in 2015, when the last buybacks took place. Buybacks at that time made sense as the earnings multiple were below 15. After 2015 there has been no buybacks and focus has been on increasing the dividend, which has seen a rise every since the spin-off. I expect buybacks to resume as soon the dividend payout ratio drops, most likely when we see a decline in the dollar.
Some investors like to say that they are “rewarded” when they get paid a dividend. I disagree: in principle a dividend does nothing for the investor, unless he consumes it. Reinvesting a dividend is a very poor way of compounding because the reinvestments are done above book values (but paid out from book value). I covered this in an earlier article.
As of writing the dividend yield is 6.35% and is covered by free cashflow. Free cashflow in 2018 and 2019 was around nine billion, and the annual dividend is around 7.3 billion for 2020. For now the dividend should be safe, but a strong dollar is working against PMI (see more below).
Reason number seven: Recession proof
The stock might not be completely recession proof, but probably the closest you can come, together with some healthcare stocks. Their operational results show a lot of resilience. Even during the Covid-19 crisis the sales have so far been little affected, except for tax-free sales on airports. During the GFC in 2008/09 PMI’s share price fell 40% at the most, but operational numbers did not decline.
A sidenote: Studies show that smokers actually are less likely to fall ill from Covid-19. What the implications will be are too early to tell, but sales for 1Q2020 was better than expected, but one reason for this was inventory buildup in certain markets, especially in Russia and Eastern Europe. 2Q is usually a stronger quarter than 1Q and the next quarterly report will give us more clues.
Reason number eight: Well known brands
Even non-smokers like myself know all the brands of Philip Morris. The best known is perhaps the most iconic of them all: Marlboro, which has been the best selling cigarette since 1971. Their other brands are L&M (4th best selling), Chesterfield (7th), Philip Morris (9th), Parliament (12th) and Street Bond (15th). Today IQOS is increasingly getting known.
Reason number nine: Reasonably qualified management
Altria and Philip Morris have performed the best among the tobacco stocks since the beginning of the GFC in 2008/09. This is something I attribute to their management teams, which as far as I can see have done most things correct, with an exception of Altria and the 35% JUUL acquisition. PMI has executed the transition to smokeless products really well, a first mover advantage, and I believe shareholders can expect great returns going forward.
Directors and executives own about 3.4 million shares, which equals only 0.22% of the company. The CEO, Andre Calantzopolous, owns 832 000, worth about 61 million USD, which I consider significant and should align interest with outside shareholders.
Reason number ten: Trading at lower multiples than the market
Most institutions are restricted from investing in sin stocks and thus Philip Morris receives a lot less interest from sell side analysts and mutual funds. Some vice funds exist, like US Mutual’s Vice Fund, but this of course amounts to just peanuts compared to the fund industry as a whole.
Despite all the positives mentioned in this article, the stock trades at a substantial discount to the market. Trailing PE is 15, much lower than the average S&P 500 company.
The social norm against investing in such companies leads to lower valuation and earnings multiples. Kacperczyk and Hong concluded in The Price of Sin: The Effects of Social Norms on Markets that sin stocks are valued about 15% less than the industries that are most similar.
Because a lot shareholders reinvest the dividend, a low valuation gives you more buying power for the dividend: a future net buyer wants the valuation to be below intrinsic value.
Reason number eleven: A hedge against a weak dollar
Because Philip Morris reports in USD, but has no sales in USD, the company is a hedge against a weak/depreciating US dollar. Unfortunately for PMI shareholders, the USD is the world’s reserve currency, as experienced recently during the Covid-19 crisis. Because investors want a “safe haven”, roubles, kroner, pounds, rupiahs, liras etc have depreciated a lot in 1Q2020. This means less revenue for PMI.
Is this likely to continue? I don’t know, any macro forecasts are just speculation, in my opinion. But the US has a huge deficit and wants to gradually inflate away the troublesome debt. This means a weak dollar increase earnings, and if it happens, shareholders can expect a small windfall.
Reasons not to own Philip Morris
Except for ethical reasons, I suspect a lot of shareholders invest because of the high and stable dividend. This might result in shareholders who are mostly concerned of receiving the dividend and not think like business owners.
PMI targets EPS growth at 8% until 2022, a very ambitious goal. If they achieve this, coupled with the current 6.5% dividend yield, we can expect 14.5% returns, without considering any multiple expansion. However, I’m more cautious and expect future long-term EPS growth to be much lower, probably an annual return of about 9-13% over a decade. I believe this is a conservative estimate, and besides I expect the market as a whole to return less.
Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.
(This article was published on the 28th of April 2020.)