One of the hardest things for investors to deal with is "political risk." This occurs when a government agency directly has an impact on a company's business model, often in a way that cannot easily be predicted in advance. In the past couple of years, we have seen a couple extreme examples of this.
After the oil spill, the American government pressured BP (NYSE:BP) to suspend its dividend, and BP agreed to temporarily halt its dividend to alleviate some of the fallout (even though it had the capacity to pay a limited dividend throughout). During the financial crisis, Wells Fargo (NYSE:WFC) had to slash its dividend at the Fed's behest.
In 2011, Bank of America (NYSE:BAC) learned that if you do not do the godfather routine and kiss Ben Bernanke's ring in the right way, your request to raise the common dividend for shareholders might get rejected. Whether or not you agree with the decisions, the point is that these decisions involved political interference rather than autonomous decisions by a Board of Directors.
With tobacco investing, we see a variant of this. Rather than dealing with political actors that tell the tobacco companies what they can do with their dividend, tobacco investors have to deal with legislative and judicial bodies that regularly chip away at the big tobacco business model, potentially threatening long-term profits in the sector (although, so far, Reynolds American (NYSE:RAI), Altria (MO) and Lorillard (NYSE:LO) have resisted these trends by growing profits almost annually in spite of increased regulation and taxation).
The problem, though, for shareholders of domestic tobacco companies is the fact that regulation and taxation keep increasing. You probably cannot point to any five year rolling period since the 1980s in which smoking in the United States actually became easier. In addition to the changes you can visually see by observing the world around you (higher taxes on a pack of cigarettes, places like bars and universities banning the use of tobacco, mandated changes to the labeling on a pack of cigarettes, etc.), there is one statistic that is particularly troubling for long-term tobacco investors: since the early 1980s, tobacco volumes have been declining by 3% annually. So far, Altria, Lorillard and Reynolds have been able to handle this.
But if I had to invest in tobacco, I would not look to either of those three companies. I'd be focusing my attention on Philip Morris International (NYSE:PM). The business model for Philip Morris International is much more favorable than what the old guard tobacco companies in the United States must address.
While American tobacco companies have to deal with declining volumes at home, Philip Morris International gets to deal with "real growth." The company is expanding rapidly in the loosely regulated African markets. The Marlboro brand is growing in Asia (particularly China) by boosting its tiny presence in the Chinese market compared to the China National Tobacco Corporation:
Marlboro is the world's top-selling cigarette, but it has a minuscule 0.3% share of the market in China, where roughly a quarter of the population smokes…
Philip Morris got its foot in the door in China in 2005, when it inked a strategic partnership with China National Tobacco, or CNTC. Under that arrangement, CNTC began producing Marlboros under license in China four years ago. Philip Morris also helps distribute CNTC brands outside China, including Poland and the Czech Republic.
Not only is Philip Morris International beginning to participate in the lucrative Chinese market, but the company has been just about minting money in the fast growth Indonesia market:
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 region, Indonesia.
The Indonesian market is marked by several trends favorable to the tobacco industry like 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 towards premium brands, rampant tobacco advertising and relatively lenient government policies to reduce or check tobacco consumption have also fueled market growth.
While the domestic American tobacco companies have to deal with shrinking markets, Philip Morris stands to benefit from increased market share for flagship brands like Marlboro that currently have a negligible presence in China, but the company also stands to benefit from volume growth in Indonesia and the expansion into a new frontier in Africa. If you are looking to make a tobacco investment with a 15+ year time horizon, an investment in Philip Morris International comes with these kinds of favorable growth tailwinds that are not presently apparent in the American market.
And lastly, because Philip Morris International generates its profits in rupiah, yuan and dozens of other currencies across the globe, the company is able to hedge against the US dollar in an attractive manner. Since 2008, the company has reduced its share count from over 2.0 billion to 1.6 billion by playing the currency game like a fiddle, extracting profits in currencies that are trading favorably compared to the US dollar and using them to destroy blocks of shares and increase the earnings per share figures for shareholders (and facilitating future dividend growth by reducing the number of shares to which a dividend must be paid).
Am I shareholder right now? No. Philip Morris International is trading at a strong P/E multiple for a tobacco company, as the current price of $95.68 gives investors a P/E ratio of 18.4 relative to $5.20 in earnings. Philip Morris has a limited trading history (as it was essentially born during the start of the Great Recession in 2008), but American tobacco companies had long ranges of trading between 9-12x earnings in their respective histories. Philip Morris International has a greater growth story, and I would be willing to pay up to 14-15x earnings, but in my case, there is no margin of safety to adjust for the political risk of tobacco investing at the current price of 18-19x earnings. With tobacco companies, if you are patient enough, you have a decent chance of getting your price.
My intention towards Philip Morris International is to buy at 14-15x earnings, reinvest the dividends into "no-brainer" high quality stocks like Coca-Cola (NYSE:KO), Procter & Gamble (PG) and Johnson & Johnson (NYSE:JNJ), essentially executing a blended strategy that allows me to participate in Philip Morris' promising growth story while hedging my bet in the event that the political risk of tobacco investing proves to be more significant (or swifter) than I anticipate.
Operationally speaking, Philip Morris International has a lot going for it. Volumes are growing significantly in Indonesia. Marlboro may become a meaningful part of the Chinese equation in the next five years (when a quarter of the people smoke, you do not have to make too many inroads to realize substantial profit). The company is able to use its diverse body of profit collection in different currencies to opportunistically buy back shares. Right now, Philip Morris is a triple threat company: it is buying back meaningful amounts of stock, giving income investors substantial raises, and experiencing organic top-line growth.