Philip Morris - Not A Smart Investment Choice Anymore

| About: Philip Morris (PM)

With researchers highlighting the adverse impact of smoking and how it impacts our lives, the tobacco industry is undergoing a major shift. Through history, tobacco companies have been considered defensive stocks due to their ability to stick around in spite of unfavorable economic movements. However, the global demand is declining, and this entails significant financial outcomes for the related companies. This article is focused on discovering the long term prospects of Philip Morris International Inc. (NYSE:PM) as a function of changing industry scenarios, adverse movements in currencies around the globe, and probable bans on tobacco products in certain regions.

Philip Morris extracts 35% of its net revenues from the European region, 26% each from EEMA (Eastern Europe, Middle East, Africa) and Asia, and 13% from the Latin America and Canadian region. The revenue chunk from Eastern Europe has declined from 39% in 2011 to 35% in 2013 while EEMA's revenue contribution is gradually increasing.

The declining industry shipment volume is indicative of the fact that the global demand for tobacco is faltering rapidly. For the present year the global industry volume is expected to decline by 6-7%. The decline is stemming out of rising excise taxes that are imposed on cigarette purchases in many countries around the globe. Specifically for Philip Morris, shipment volume has dropped by 5.1% to 880.2 billion units as of the full year earnings release for 2013.This drop is majorly attributed to the Philippines, excluding which, the drop in shipment volume is just 2.7%. With the net revenue decline, the gross profit of the company squeezed by approximately 0.4% compared to last year's. The operating margin of the company slumped by a higher percentage (1.1%) as the company increased its investments in R&D and marketing operations.

Despite tough times, the company maintained the ability to continue to increase dividends for some time into the future. Philip Morris has been frugal in its approach but has always managed to pay a healthy level of dividends ever since its spin-off from Altria Group Inc. (NYSE:MO). The dividends paid by the company have grown at a CAGR of more than 100% since its spin off. Moreover, the company retained a healthy level of cash flows despite continual dividend increases. However, this trend will change in the future if the industry does not pick up again. It seems highly unlikely that the industry will take a positive turn now as consumers are becoming increasingly aware of the devastating impact of tobacco use on their overall health, productivity, and general lifestyles.

Philip Morris also distributes cash among its shareholders through share repurchases when feasible. Since 2008, the company has repurchased 556.2 million of its shares and plans to spend another $4 billion in this regard by the end of 2014. Note that the $4 billion figure is a downward revision from the previously decided figure of $6 billion. The international operations of the company are expected to take a severe hit due to currency depreciations. Adverse currency translations are a huge concern for the company as Philip Morris stretches across various geographical territories. Adverse currency impact hits the top line, thus lowering the actual revenues of the company. The negative impact on the top line trickles down all the way to the bottom line. With that the cash flows from operations are affected which in turn affect the decisions regarding share buybacks or dividend payments. Anticipating major currency headwinds in 2014, the company lowered its cash flow allocation to the share buyback program this year. The company also lowered its revenue and earnings estimates for the year.

Moving on to the industry and looking specifically at the developed regions the anti-tobacco campaigns are gaining strength and leading to the imposition of laws and regulations that have a negative impact on the manufacturers' profit margins. Regulations regarding e-cigarettes are still being debated since a lot of research is yet to be done on e-cigarettes to fully understand their impact on the health and lifestyles of consumers. The European Commission has not yet announced an e-cigarette ban but has clearly stated that it might impose an EU-wide ban if at least three other member countries prohibit their usage due to health concerns. An EU-wide ban is a matter of concern for the company since it generates a large chunk of revenue from this region.

From 2016 onwards, the marketing and branding of cigarettes will be largely banned as well requiring tobacco product manufacturers to cover 65%of their packaging with warning text and graphic messages. Moreover, the new regulations put a ban on fruit and vanilla flavored cigarettes. Menthol cigarettes will be phased out of the industry by 2020 as well. None of these regulations seem to support the ongoing growth of tobacco companies.

With regards to the developing countries, adverse economic conditions are hampering the sales of Philip Morris' products. The company generates a large chunk of its revenues from Marlboro, which is a premium priced product of the company. As a result, Philip Morris has lost some of its market share to its rivals as consumers move on to cheaper products. Imposition of higher excise taxes on tobacco based products does not help the company either.

Wrapping up, my research does not indicate a bright future for the company. I would not recommend an investment in this stock based on the following reasons:

  1. Consumers are becoming increasingly aware of the harmful effects of tobacco use and are gradually omitting tobacco based products from their lives.
  2. The current level of cash flows and dividend increases are not infinitely sustainable in the future if the revenue base and market share continue to decline.
  3. The impact of currencies is getting worse with the passage of time.
  4. New laws and regulations, combined with anti-tobacco campaigns, have significantly impacted the financials of the company.

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.