Philip Morris - Why I'm Worried

| About: Philip Morris (PM)

Tobacco was the first crop grown for money in North America, planted in 1612, or just over 400 years ago. However, the Mayan civilization carved drawings of tobacco use as far back as 900 A.D., and smoking has been dated as far back as 5000 B.C. in some rituals. Cigarettes were first mass-produced by the American Tobacco Company, with the invention of a cigarette-making machine, in the early 1880's. Production went from 10 million cigarettes the first year to about 1 billion in the fifth year. About a decade later, in 1902 the Philip Morris (NYSE:PM) company came out with its Marlboro brand. Through some brilliant marketing, such as sending free cigarettes to soldiers during WWI and WWII (among other wars and strategies), Marlboro has become one of the largest, and most profitable brands in the world. Philip Morris International wisely was spun off from what is now known as Altria (NYSE:MO), in part to avoid continuing to pay into the Tobacco Master Settlement Agreement or MSA. Philip Morris and Altria continue to sell the same products, in different markets. Philip Morris was created to avoid the challenges of the U.S. market, such as the MSA. The MSA required the four largest tobacco companies in America to collectively pay a minimum of $206 billion over the first 25 years of the agreement. Notice the "first" in the previous sentence, how much will subsequent agreements cost after the first 25-year period? Currently unknown, but the agreement requires annual payments to the states into perpetuity, so I believe spinning off the international division was a very intelligent long-term strategic move. One of many brilliant moves the company has made over the years.

Philip Morris now sells over 25% of the world's tobacco, outside of the United States and China. Philip Morris will never sell another cigarette in the U.S. where its counterpart operates, but in the coming years I would expect it to break into the Chinese market as China becomes less of a communist country and more of a capitalistic country. China has roughly 300 million smokers, and someday they will experience a Marlboro or another Philip Morris brand cigarette.

Philip Morris is one of the most profitable companies in the world, with net income of nearly $9 billion and growing, spread out between 1.6 billion shares and shrinking. Since becoming its own company, Philip Morris has reduced share count by roughly 25%, in 5 years! They have also continued to raise their dividend distributions every year, from $.46/qtr initially in 2008 to $.85/qtr today, and will increase it again this September. My guess is they will raise the dividend to $.92/qtr, which is roughly inline with their goal of a 65% payout ratio, and would be a perfect double of the initial dividend in 2008. The dividends are well supported by earnings which are also increasing every year and expected to rise by >10% a year for the next 5 years. Free cash flow to sales ratio has been roughly 10% a year since the spin-off, which means that saying "PM is a cash cow" is an understatement. A traditional metric of RoE cannot be taken at face value because of the debt that PM is taking on to support the share buybacks, but RoA is an astounding 23% average since the spin-off, which most companies can only dream of. Here is a list of companies I also think are fantastic.

So what am I so worried about? Is it the debt load to finance the buybacks? That seems to be a turn-off to many investors who look at shareholders' equity. But the answer is no, the debt can be paid off from the cash flow without threatening the dividend. The recent drop in share price after Bernanke rattled the markets was unwarranted but not unwelcome. The FED laying off buying securities as the economy improves, really has nothing to do with Philip Morris, and the astute investor read between the lines and understood that interest rates will remain near 0% for several more years and bought more shares near $86 (I did). It's the interest rates that Philip Morris uses to get cheap money, not QE. The reduction of float in the last few years, and the average price per share paid, has been nothing short of astounding management. I cannot find fault with the decisions they are making now. The bottom line, Philip Morris has a stellar A- bond rating for a reason.

What I am worried about is Australia, selling cigarettes in drab, olive-green brandless packaging. Ireland appears to be following suit, and many other countries (Britain, Canada, New Zealand, China, France, India, South Africa, Norway and Uruguay) have mentioned doing this as well. Ideas are floating around from putting nasty pictures on the cigarette box, uniform or non-existent branding, among other things. I don't understand how this is legal anyways. If you drink a case of Coca-Cola (NYSE:KO) a day, you will probably get diabetes, so should every can of Coke have a picture of an amputated foot? Should every Coors Light (NYSE:TAP) have a picture of a FAS (fetal alcohol syndrome) baby on it? Should every McDonald's (NYSE:MCD) meal have a picture on the bag of a morbidly obese family? Should every case of bullets bought have a picture of someone shot between the eyes? I don't understand why the world is doing this, which frankly scares me. I have long planned on holding PM until retirement, as it has been my largest holding since I began investing, but it's scary to think about what the future holds if international governments continue along this path. Philip Morris has spent billions in advertising and marketing to create one of the most recognizable brands in the world, and some governments believe they can do away with branding. But again it's only the tobacco industry brands the governments are fighting. How many industries can survive without advertising, marketing, or a brand? Would high-end gun manufacturers still survive if all the guns had to be produced with only serial numbers and no branding and looked like all the other guns? A brand is everything.

Philip Morris sells a plant that's been used for a century of centuries. As Warren Buffett eloquently put it, "I'll tell you why I like the cigarette business. It costs a penny to make. Sell it for a dollar. It's addictive. And there's fantastic brand loyalty." Revenues, earnings, and dividends are all increasing, share count is decreasing, management has made some brilliant moves over the years and continues to be extremely shareholder friendly. I have always believed that PM will saturate the world in 50 years as Altria has done today in the U.S. and eventually will have a 6% dividend yield like Altria and I will be able to retire on a yacht through reinvested dividends until retirement. But at the current pace of international government crackdowns, I'm worried the future is not as bright as the past has been. I hope I am wrong, please comment and let me know your thoughts, I would like to hear them.

Disclosure: I am long PM, KO, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.