Philip Morris International (NYSE:PM) -- the global tobacco giant that sells cigarettes in over 200 countries -- manufactures and markets Marlboro, the No. 1 cigarette brand, which holds more than 9% market share by volume worldwide (excluding China and U.S. cigarette volumes). After the spin off from its earlier parent company Altria in 2008, the company has delivered shareholder returns of approximately 120%, far more than the tobacco peer group returns of 65% during the same period (excluding dividends).
Asian markets have been the best performing segment for the company since 2009, helped by volume growth and rising market share. Revenue from Asia as a percentage of total revenue has grown from around 26% in 2009 to 36% in 2012. This has been at the expense of falling relative share of the European region markets that have been marred by deteriorating macroeconomic conditions and industry-specific indirect tax hikes.
Our near $86 price estimate suggests that Asian operations contribute to more than 45% of the company's stock value. Here we will be focusing on the key trends among the most important Asian markets for Philip Morris International.
The China Story
China has the largest tobacco industry in the world, which accounts for more than 40% of the total cigarettes consumed globally and is almost completely state owned. Philip Morris is the only company to have a license agreement for it's biggest brand Marlboro with the Chinese National Tobacco Corporation (CNTC). However, operations in China are very limited and until the Chinese government decides to open up the industry for foreign companies, it's not expected to change significantly. Philip Morris is working on an alternative route to enter the Chinese market through some low-risk innovative products that can give it an advantage. But these products are not expected to be launched any sooner than 2016, and the company's success in entering the humongous market is very uncertain, which is to be accounted for in our current price estimate.
Other important Asian markets for Philip Morris are Indonesia, the Philippines, and Japan. These markets contribute to around 78% of the total cigarettes shipped by the company in Asia. The largest contribution (33% of the total cigarettes shipped in Asia) comes from the fastest growing -- Indonesia.
Favorable Trends to Keep Indonesia Smoking
The Indonesian market is marked by several trends favorable to the tobacco industry like a high smoking prevalence rate (highest male smoking rate in the world of 67%), relatively lower cigarette prices, and increasing affordability led by rising income levels. A volume shift toward premium brands, rampant tobacco advertising, and relatively lenient government policies to reduce or check tobacco consumption have also fueled the market growth.
Another factor dampening anti-tobacco moves of the local government is the important role that the tobacco industry plays in the national economy. The country hosts world's fifth largest cigarette manufacturing industry that contributes almost 3% of total cigarettes consumed globally. The taxation of tobacco companies contributes around 10% to national revenue and also provides around 10 million jobs directly or indirectly.
However, earlier this year a couple of measures were taken by the local government to tighten the noose on tobacco companies. Excise tax on cigarettes was hiked by 8.5% and a law requiring cigarette packets to bear graphic warnings was also introduced. But relatively low price elasticity of demand of cigarettes (around -0.3) would imply around 2.5% volume decline over time due to the 8.5% excise tax increase.
We believe the impact of these measures would be more than offset by the country's favorable trends discussed above. Hence, we expect the industry volume to grow at a healthy 5%-6% rate in the long run.
Sin Tax Law in Philippines to Drive Sharp Decline in Volume
Cigarette shipments made by Philip Morris in Philippines made up 29% and 28% of the total volume shipped by the company in Asia region during 2011 and 2012, respectively. However, going forward we see that metric falling significantly due to the historic "sin tax" law implemented in the country on Jan. 1, 2013.
Under the law, cigarette packs with a net retail price of Phillipine peso 11.50, excluding excise and value-added taxes, will have a P12 excise tax, while those with a net retail price tag of over P11.50 will be imposed with excise tax of P25. These rates are planned to be raised incrementally until 2017, after which every single pack sold will be charged with a P30 excise tax. This compares to a P2.7 excise tax on low-priced cigarette until only last year. As a result of this move, Philip Morris' most popular premium brand in the country -- Marlboro Lights -- is carrying a P25 tax, up more than 100% from the previous year.
Such a sharp hike in excise tax on cigarettes is expected to drive the company's shipment volumes in the country significantly lower, in comparison to previous years. Even a very conservative estimate of price elasticity (-0.1) would imply a 10% decline in volume in 2013 due to the base effect. However, in the long run we expect the rate of decline in volume to be around 2-3%. Although cigarette companies would try to neutralise the impact of lower volumes by higher prices, we expect revenues to be negatively impacted as well, largely due to increase in illicit trade of cigarettes as a consequence of higher excise taxes.
Overall, we expect Asia to remain the key growth driving region for Philip Morris, as volume and pricing gains in Indonesia are expected to more than offset sharp volume decline in the Philippines. Moreover, revenue growth from Korea and Pakistan and stable revenues from Japan are expected to translate into 6%-8% long-term revenue growth from the region for Philip Morris International.
Disclosure: No positions.