With Philip Morris International (NYSE:PM) hitting its 52-week low of $75.28 per share earlier this week, it seems to have finally entered the territory of "high growth company at a good price." The company is one of the few stocks in the market that offers a starting yield just shy of 5% and has a habit of growing profits and dividends in the vicinity of 10% over the course of a typical business cycle.
Since last May, the price of Philip Morris International has declined 23%, while the S&P 500 has been up 10%. Before diving in to why Philip Morris looks like a good buy, it could be worth taking a moment to size up the rational reasons why there has been a thirty-three percentage point spread between the performance of Philip Morris International and the S&P 500 over the past nine months.
First of all, 2013 marked the first year since the onset of the financial crisis in which Philip Morris failed to actually increase its net profits. It made $8.8 billion in profits in 2012, and profits came in just below that in 2013. But because the company throws off so much cash to run a committed buyback program, it has been able to reduce its share count from 1.653 billion (at the end of 2012) to the 1.60 billion mark. In other words, although profits have held steady, each share now represents $5.40 in profits instead of $5.17 in profits due to the company's strategy of regularly taking shares off the table.
This year of stagnant profits has likely been driven by two developments: trouble with volumes in the European Union, and increased taxes on Russian products.
Almost one out of every three dollars in profits generated by Philip Morris International comes from the countries in the European Union. Well, over the past year, the volume shipments of Marlboro, Chesterfield, and Parliament have declined 5%. The risk for investors is that this is not an aberration, but rather, part of a larger downward trend that has seen EU volume shipments decline by over 20% since 2006.
The other concern is the 40% increase in Russian excise taxes on tobacco consumption. A great read on the topic can be found from CEIC data here, but here is the important part of the conclusion:
Statistically, these years represent a turning point. Prior to 2007, cigarette sales in Russia were steadily rising, but after peaking at 424 billion packs in that year, annual sales steadily diminished to 398 billion in 2008, 371 billion in 2011 and 363 billion in 2012. The accelerated decline can be attributed to the excise tax increase, as its rate of growth had been steadily increasing. However, if any significant conclusions are to be drawn about the efficacy of the policy of economically starving nicotine addicts, it has to be done after 2014, when we can analyse data for sales in 2013 and the subsequent tax collection rate.
In short, if volume declines in the European Union and Russia keep up, Philip Morris will have to rely upon volume growth in Southeast Asia indefinitely if it wants to keep its status as the tobacco giant that not only grows profits over the long-term due to buybacks and pricing power increases, but also due to growth in volume shipments as well.
Of course, the testament to Philip Morris' earnings quality and management strategy is that, despite some very deep headwinds in 2013, the company still managed to grow each share of profits by 4.44% in this past year despite rough challenges to its business model in the European Union and Russia.
John Neff and Donald Yacktman regularly advise seeking out companies with high-quality earnings that are facing a solvable problem. In the case of Philip Morris, the volume declines of 5% have been on the steep end of the curve due to excise tax increase programs, and with that legislation now fully absorbed into the company's business reality, it seems that a return for smaller declines or modest volume growth in the EU will be in the offing.
Since 2008, Philip Morris has retired one out of every five shares in existence. In the past year or so, the buyback has been responsible for the company's growth in earnings per share, but it appears that the company is about to turn the corner and offer both actual profit growth in addition to share buybacks due to price increases and volume growth in Eastern Europe, Southeast Asia, and Africa.
That's what could make the company's profit potential quite lucrative over the next four to five years: the company could easily be making $13 billion in net profits by the end of 2019 due to pricing and volume growth in the three regions mentioned above, as well as a softening of volume declines in the EU and Russia that ought to lead to increased profitability.
In that regard, Philip Morris is like a coiled spring right now. Not only is the earnings power of the company set to increase in the next five years, but you also get a dividend of nearly 5% off the start, which is currently mixed with a low valuation of 14-15x earnings.
If the company's valuation reflects its earnings quality and tilts towards a 17-18x earnings valuation over the long term, investors could benefit from the sliding scale of rising valuation, growing profits, and a high current dividend payout. If you take into account the company's buyback pace and estimate $13 billion in net profits by the end of 2019, that would allow the company to be making about $8.25 per share. At 17-18x earnings, that would be a stock price in the neighborhood of $140-$148 if the company is rationally valued come 2019, and that does not even take into account the 5% and growing dividend, which will also be a substantial addition to returns.
John Neff once called high dividends the equivalent of appetizers that allow you to snack while waiting for the main meal (fair valuation) to arrive. In the case of Philip Morris International, you are getting almost 5% of your investment returned to you each year as the starting point. A well-supported, high dividend is a margin of safety in its own right. When you adjust for the prospect of continued buybacks and a rising P/E multiple, and factor in the expected profit growth in Eastern Europe, Southeast Asia, and Africa, current investors that buy in the $75-$80 range should be able to do quite satisfactorily even if volume troubles in the EU and Russia prove to be a continuing bogeyman for shareholders in the coming five years.