Philip Morris International: Risk To 15% Downside In Near Term

Aug.27.13 | About: Philip Morris (PM)

Shares of Philip Morris International (NYSE:PM) have rewarded vice-stock investors, returning an annualized 16% since the spinoff in 2008 including a dividend that has been increased 85% over the period. Despite the potential to outperform over the long-term, shares have dropped almost 6% in the last year and could fall further on regulatory risks over the next year. The stock is trading at price multiples around the high end of its three-year range and investors may want to hedge near-term weakness with options or wait for better prices after regulatory event risk.

Strong support from long-term catalysts

The company reported net income of $1.30 per share last quarter, down 8.3% from the same period last year and missing analyst estimates for $1.41 per share. Earnings per share took a $0.07 hit on foreign currency weakness relative to the dollar. While international revenues have detracted from the bottom line recently, they should provide support over the longer-term as fiscal deficits and sluggish growth weigh on the dollar.

Another positive catalyst over the longer-term is the company's development of safer alternatives. CEO Calantzopoulos announced in June that the company was on the eve of a, "paradigm shift for the industry," with three alternatives to traditional smoking. While the most promising alternative, a product that would heat the tobacco instead of burning it, is ready for clinical testing, manufacturing is still at least three to four years out.

The company has yet to really break into the Chinese market, which accounts for approximately a third of the international market for tobacco, and should see significant support on any progress in the country. There are 1.2 billion smokers in China alone, almost four times the population of the United States.

At current valuation, risks outweigh reward

The short-term risks come primarily from a wave of packaging laws passed or proposed around the globe. The European Union, Thailand and Uruguay have all recently proposed legislation that mandates 75% to 85% of cigarette packaging must contain text and photo warnings. The E.U. proposal also bans some promotional elements and allows member states to pass their own plain-packaging laws. The industry has had some success blocking these types of regulations through litigation on the grounds of trade and brand infringement but many cases are still pending.

Other plans, like Australia's requirement that all cigarettes be sold in uniform brown packs that limit the size of brand labels are possibly the most detrimental. Any regulation that limits the effectiveness of brand could hit Philip Morris and lead smokers to buy less expensive generics or roll their own cigarettes.

Philip Morris currently holds $3.5 billion in intangible assets on its balance sheet, more than 9% of its total assets. While the company sells the strongest brands in the industry, a portion of these assets could be at risk to impairment if widespread packaging laws are passed.

The shares are trading at 16.5 times trailing earnings, off the valuation of 18 times achieved last year but at the high end of the 10-18 times range in which the shares have traded since 2009. The passage of packaging regulation could hit sentiment particularly hard as it would be expected that other countries would follow through on their own regulations. If the valuation dropped to the midpoint of its near-term range, say 14 times trailing earnings, current investors would see their shares drop by 15% to around $72 per share.

Selling the January 2015 calls with a strike of $85 against a position in the shares protects investors against an almost 7% drop in the price. You will collect $5.85 per share and still keeps the healthy dividend yield until expiration. You could then buyback the calls in the event the share price plummets or may hold them to expiration. Alternatively, you may want to buy put options for the right to sell the stock at a predetermined price. This completely limits the downside risk and maintains the potential for upside return, but will cost you for the protection.

While brand loyalty is strong and there are upside catalysts, investors need to remember that this is a fairly mature industry and global revenue growth will remain in the single-digits. Current investors may want to hedge their downside risk in the near-term while new investors may want to wait for a better entry point. Watch for the passage of regulation on packaging and the possible impairment of goodwill in the following quarterly earnings, then work into a long-term position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.