Is Philip Morris Overvalued?

Oct.18.13 | About: Philip Morris (PM)

[Editor's Note, October 23: This article has been revised since original publication, as the author has made changes to the content]

The tobacco industry is currently experiencing a number of challenges that are adversely affecting the industry's overall business and financial strengths of many tobacco companies. Tobacco legislation and regulation, excise tax increases, governmental and private restrictions on smoking, illicit trade and the efforts to "de-normalize" smoking are some of the factors upsetting the companies in the industry.

The trend has also affected Philip Morris International (NYSE:PM), which is facing much litigation due to the extreme regulatory requirements put in place by international governments. As of August 1, 2013, there were 74 smoking and health cases against the company brought by individual plaintiffs in different regions of the world. Besides that, claims against the company have also been brought by government representatives. These claims adversely affect the financial position and brand equity of the company and eventually damage its investors.

To determine how much potential the company's stock possesses, we must explore its historic performance and future outlook.

Historic Performance

After posting slightly poor performance in the second quarter of 2013, Philip Morris was able to improve its financial health in the third quarter. The year-on-year growth in the third quarter was 5.3% whereas in the first and second quarters, its year-over-year growth was only 2.8% and 2.2%, respectively. However, there were no significant changes in the QoQ growth in the third quarter.

In the third quarter, the company’s cigarette shipments decreased by 5.7% due to the overall declining demand for cigarettes in Russia, Philippines, Pakistan etc. This decline was the direct consequence of the unfavorable impact of excise tax-driven price increase, the share growth of the substitute tobacco products, the weak economic and employment environment, the prevalence of non-duty paid products and increase in illicit trade. The company’s market share has increased in a number of other key markets, which include Canada, UK, Brazil etc.

Source: SEC Filings

Its QoQ operating margin in third quarter has improved by 1.15%. On a year-on-year basis, the operating income has declined by 1%. If we exclude the unfavorable currency impacts, the operating margin has improved by 3%. The nine months ended reported income was up by 1% after excluding the unfavorable impact of currency.

Net revenues increased by 1.6% in the third quarter. This increase was primarily driven by favorable pricing impact of $488 million across all regions, partially offset by unfavorable volume/mix of $361 million. The diluted per share earnings in the third quarter 2013 increased by 9.1% on a YoY basis.

The decrease in second quarter margins was primarily due to the higher manufacturing costs, higher marketing, administration and research costs and unfavorable volume mix and currency impacts. The lower operating margin along with the higher interest expenses led to a lower net income margin. The diluted and basic EPS of the company each declined by 4.4% in the second quarter of FY 2013.

The company currently carries $23,132 million of debt. Its debt-to-asset drastically shot up at the start of the year 2013, due to a slight decrease in its asset level and a significant increase in the debt level. The company designates certain foreign currency denominated debt. At June 2013, the foreign currency debt includes mortgage debt in Switzerland, debt from business combination in Philippines and other capital lease obligations.

Source: SEC Filings

The higher debt level reduced Phillip Morris’s EBITDA to interest expense ratio from 15.6 in the first quarter of 2013 to 14.8 in the second quarter of 2013. This higher interest expense is mainly responsible for affecting the company’s net earnings adversely. However, in the third quarter 2013 the company’s debt-to-asset ratio decreased by approximately 6% compared to the second quarter 2013. This decrease was brought by a 214% reduction in the current portion of the company’s long-term debt. Despite the decline in the company’s debt, its debt-to-EBITDA ratio is worse than the ratio posted in the same quarter last year.

New Generation Products

Philip Morris is working on broadening its product portfolio. The company is developing and commercializing a portfolio of innovative products, which could reduce the risk of smoking-related diseases in comparison to conventional cigarettes. Currently, five studies are underway and three have been submitted to the regulators. The electrically heated tobacco products of the company were tested on a consumer platform and received wide acceptance among adult smokers.

The efforts include developing modified-risk tobacco products that provide the same taste and sensory experience as conventional cigarettes while eliminating the level of risk in individual smokers and the population as a whole. These products named 'new generation products' (NGPs) will meet the requirements of the US regulatory framework under the jurisdiction of the Food and Drug Administration. The results of these products are expected in 2014. As the smokeless product segment is becoming the fastest growing segment in the US, the NGPs of Philip Morris will help improve its revenues. Moreover, the high chances of the regulation of e-cigarettes from the FDA will further boost the demand.

Valuation

To derive the fair value of the company’s stock I have employed the dividend discount model. To calculate the required rate of return CAPM model was used. I assumed expected market return of 12.3% taken from the S&P 500 in the post financial crisis period, risk free return of 2.7% taken from the 10-year long-term treasury bond yield and a beta of 0.90 taken from Yahoo Finance. After applying these values, the expected return comes out to be 11.34%.

The company’s management expects the full year 2013 dividends to grow by 10% to 12%. Keeping in view the improving margins, decreasing debt level and increasing dividends of the company, I have assumed a growth of 10.6%. I expect this growth rate to increase for next year as the new generation products are launched in 2014, which could considerably enhance the company’s earnings. Thus, an expected price of $68.99 has been derived by applying the dividend discount model. This indicates that this stock has a downside potential of around 21%.

Final Thoughts

Phillip Morris has been highly affected by the stringent government regulations introduced as depicted by its poor financial performance in the first half of the year. But in the third quarter, the increasing market share in some of the key markets and the favorable volume/mix has positively impacted the company’s third quarter earnings. The company has also reduced its debt in the recent quarter, which would reduce its interest expense and improve its margins in the upcoming periods. However, the litigations can greatly affect the company’s brand equity.

The valuation of the company’s stock through dividend discount model tells us that the stock is currently overvalued. However, the company’s position is expected to get better in the next one or two years after the launch of its new generation products.

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.