- PM's price weakness over the past 12 months has created an attractive entry point.
- Current valuation at 10% discount to market has likely reflected most of the headwinds.
- Identifiable upside catalysts include performance recovery in key markets, development of new products, and currency stabilization.
Share price of Philip Morris International (PM) has lost 14% over the past 12 months, compared to a 20% gain for the S&P 500 Index. In my view, the price underperformance presents a great buying opportunity for this high-yield stock, as I believe PM's cheap relative valuation has already digested most of the bad news, allowing a large upside opportunity driven by any positive surprises.
In the recent earnings call, management indicated that PM continues to experience the following near-term headwinds:
- Negative FX development has been weighing on PM's performance. The FX drag remained notable in Q4 2013, with an $0.11 impact on the quarterly EPS of $1.37. Looking forward, management expects the 2014 EPS to grow by 6% to 8% on a constant currency basis, which is below the long-term growth potential (i.e. 10% to 12%).
- Owing to the FX pressure, management noted that maintaining PM's credit rating and investing in new products will be the top priority, and therefore management anticipated a lower level of share buyback (i.e. $4B in 2014 compared to $6B in 2013) in 2014.
- Aside from the above, management provided a challenging 2014 volume guidance in PM's key markets. Management expects a volume decrease of 6% to 7% in Europe, 9% to 11% decrease in Russia, 3% to 3.5% decrease in Japan, and a 1% volume increase in Indonesia.
The stock now trades at 13.9x 2015 forward P/E multiple, which is at a 10% discount to the same multiple of the S&P 500 Index that is at 15.4x (see chart below).
Given that 1) PM traded at an average premium of 2% over the market in the past 12 months; 2) PM's consensus long-term earnings growth potential (at around 8%) is fairly close to the average estimate for S&P 500 companies; 3) the stock offers a 4.8% dividend yield that considerably exceeds the market average at just 1.9%; and 4) the stock also benefits from a sizable buyback plan (although it was lowered to $4B for 2014), which represents 3% of the current market capitalization and has reduced the total share counts by 22% since 2008, I believe the 10% valuation discount has already reflected most of the near-term headwinds and should mean that the risk is to the upside.
Looking forward, I expect the following developments would have the potential to drive upside surprise:
- As mentioned earlier, management guided a 6% to 7% decrease in volume in Europe for 2014. This is an improvement from the prior guidance of 7% to 8% decline. Given the fact that the European volume had been modestly improving throughout 2013 and was down by just 5.5% in the second half of 2013, I consider management's revised guidance to be on the conservative side, leaving room for positive surprise.
- PM's past performance in Philippine was weighed by a large tax increase and low price from Mighty Corporation, a local competitor. Owing to regulatory scrutiny, Mighty reacted with a price increase in November 2013. Given the increasing social scrutiny and the fact that Mighty could be under-declaring 50% of its volume for tax purpose, the price increase is expected to continue and this would directly benefit PM's volume trend and profitability in the Philippines in 2014.
- One of the main factors weighing on management's 2014 EPS guidance is the investment for Next Generation Products, which is aimed to improve the company's longer-term growth potential (i.e. beyond 2014). Given the materiality of this development and the fact that the Street's current consensus long-term earnings growth estimate at 8% is only slightly better than management's 2014 EPS growth guidance (6% to 8%), I am of the view that the market is likely underestimating the upside potential from this project.
- Of course, both the Street and management's current 2014 estimates reflect a bearish FX outlook. As such, any signs of stabilization for emerging market currencies should have a positive impact on the share price.
In summary, PM is poised for an upside as the stock valuation has baked in a very bearish scenario. Continued recovery in the company's key markets, development of the Next Generation Products, and currency stabilization are expected to narrow PM's current valuation gap to the market.
All charts are created by the author and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.