Philip Morris (PM), the world's leading tobacco company, has delivered solid financial performance in recent years. I reiterate my bullish stance on the stock, as it offers a solid dividend yield of 4.3%, has a diverse revenue base, and has attractive valuations in comparison to its industry average. Based on my price target of $107 (calculations shown below), the stock offers a potential total return of approximately 30%; a dividend yield of 4.3%, and potential price appreciation of 25%.
Last week, PM reported a better-than-expected financial performance for 3Q2013. PM reported adjusted EPS of $1.44 for 3Q2013, up 4.3% year-on-year, beating analyst expectation of $1.43 per share. The earnings beat for the quarter was the first one in the last three quarters, which managed to restore investor confidence to a certain extent, and had a positive impact on the stock price. Earnings for the quarter were positively impacted by a better top line, lower tax rate and lower corporate expenses.
The company reported net revenue of $7.9 billion, up 0.1% year-on-year, in line with analyst expectations. As the company has international market exposure, foreign currency had an adverse impact of approximately 1.5% on the company's net revenues. Consistent with the tobacco industry, volumes for PM dropped 5.7% for the recent third quarter. Sales volume for the tobacco industry is being adversely affected by tougher regulations, and the increasing popularity of alternate (smoke-less) tobacco. In the current environment of decreasing cigarette volumes, price increases have remained an important tool for the industry to support/grow its revenues. PM also relied on price increases to offset the impact of decreasing volumes, as the price increases had a positive impact of 7.3% on the company's net revenues in 3Q2013.
Sales volume for the company was down across all its major markets. As consumer spending in Europe remains soft due to the ongoing economic crisis, volumes for PM dropped by 5.2% in the region. A big volume drop was experienced in Asia, where the sales volume was down 7.8%. Sales volume for Asia was adversely affected due to a drop of 21% in the Philippines. The challenges for the company in Philippines are related to underreporting of taxable volume by a competitor and a disruptive excise tax increase. EEMA markets also failed to portray a good picture for the quarter, as volume was down 5.5%, led by a drop of 10% in volumes in Russia; the Russian volume was mainly affected by tax-driven price increases.
An important take-away from the recent quarter's earnings release was the fact that the company lowered its full year (2013) earnings guidance. I believe that lowering the full year earnings guidance was the right measure, one that will help in removing an overhang that has created uncertainty and has kept the stock price in check. The company has revised down its full year EPS guidance to $5.35-$5.40 from the prior guidance range of $5.43-$5.53. The new earnings guidance range seems to be more realistic and achievable, as the prior (higher) guidance range seemed to be difficult to achieve given the company's weak financial results in 1H2013.
The company's management remains committed to increasing shareholders' value and sharing the company's success with shareholders. Currently, PM offers a solid dividend yield of 4.3%, backed by healthy cash flows. Also, the company has been undertaking an aggressive share repurchase program that will fuel future earnings growth and magnify ROE. PM bought $1.5 billion worth of common stocks in the recent third quarter, consistent with its full year share repurchase target of $6 billion. The company has repurchased approximately $32 billion worth of common stocks since May 2008. PM's share repurchase initiative is an important tool in the company's arsenal, which will have a positive impact on its future earnings. The following table shows PM's healthy cash flow position in recent years.
(click to enlarge)
Source: Company Reports and Calculations
Due to tougher regulations and a shift in consumer preference towards alternate (smoke-less) tobacco, sales volume of traditional cigarettes are on a decline. The company has to continuously increase prices to offset the impact of the decreasing volume; otherwise it could have a negative impact on the company's revenue growth. Also, as the company earns its revenue from international markets, foreign currency movements pose a threat to the company's top and bottom lines.
Moreover, the ongoing issues in the company's key markets are likely to persist in 2014, which could have a negative impact on PM's financial performance. In the Philippines, an increase in excise taxes on low end products could lead to higher demand for non-duty paid cigarettes, which would lower PM's sales volume. Also, excise tax is expected to continue to rise in Russia in 2014, and due to growing competition, PM might not be in a position to immediately pass on the tax increase to consumers.
Despite the challenges faced by the company in some of its key markets, I remain bullish on the stock. PM owns a dominating market share of approximately 30% (excluding the U.S. and China) and has significant international market exposure, which will fuel the company's future earnings growth. Also, the stock is trading at a cheap forward P/E of 14.50x, in comparison to its industry average of 15x.
Furthermore, the stock offers investors a potential price appreciation of almost 25%, based on my price target of $107. I calculated the price target of $107, using the S&P 500 forward P/E of 15.1x and 2014 EPS estimate of $5.96. (I applied a 20% premium to the S&P 500 forward P/E of 15.1x due to PM's significant international market exposure)
S&P 500 Forward P/E
2014 EPS est.