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Summary

  • Company’s business model and fundamentals remain intact despite difficulties.
  • Safe dividend yield backed by solid free cash flow yield makes stock attractive for dividend seekers.
  • Asian markets posing challenges to PM due to headwinds.
  • Market share issues could show signs of being resolved as early as 2015.

Philip Morris (NYSE:PM), the leading tobacco company in the world, is a popular investment prospect for dividend-hunting investors. The company has fat margins, a strong cash flow and stable dividends. However, the company has been plagued by various issues as of late, including currency headwinds and softness in several key markets, which brought stock valuations under stress and will impact performance in the short term. Also, sturdy regulations, growing health awareness and the increasing popularity of alternative tobacco products have been challenging the company's sales volume and the global tobacco industry.

Philip Morris has a geographically diverse revenue base, with significant exposure to fast growing emerging markets, something that remains an important growth catalyst. However, the diverse revenue base exposes the company to currency headwinds, which in the recent quarter affected earnings growth and the stock price. According to Philip Morris, an unfavorable exchange rate is expected to have a negative impact of $0.61 on the EPS in 2014. In my opinion, currency headwinds are now priced in, and will be less of a concern for investors in upcoming quarters.

In this article, I will discuss the tough market conditions being faced by the company in Indonesia and Japan, and signs of improvement in the EU region.

Currently, the company has been facing difficulties in some of its key markets, including Japan and Indonesia. To address these issues, the company has been taking measures. However, none of these measures are expected to provide any benefit in the short term and they will take some time before they bear fruit. Nevertheless, in my opinion the company does have the financial muscle, potential and expertise necessary to move forward and keep growing bottom line numbers in the long run.

Indonesia
Indonesia is the single biggest volume market for Philip Morris, contributing about 9% to the company's total operating income. Growth for Philip Morris in the Indonesian market has drastically slowed down because of a reduction in government subsidies, a competitive pricing environment, an increase in costs of core food staples, and changes in consumer preferences. Also, the Indonesian government's initiatives to reform its tax structure have benefited small scale cigarette manufacturers. This has in turn made the market much more competitive. In the first quarter of 2014, the company observed a 5.5% YoY drop in sales volume and its market share in Indonesia dropped to 34.6%, in comparison to 35.7% in 4Q2013. Also, the company expects the Indonesian cigarette market to grow by 1% in 2014, down from the prior year's growth of 3.4%, mainly as a result of new regulations and the ongoing inflationary environment. The prevailing Indonesian market conditions are not likely to change in the near term and will remain a headwind. However, in the long term, the company is likely to benefit from investments made to strengthen its brand portfolio. Indonesia will remain an important market for Philip Morris as it offers growth and is the third largest tobacco market in the world.

Japan and EU
Japan is another market where Philip Morris is struggling to maintain its market share. This has been the story for some quarters now; Philip Morris' market share dropped by 200bps YoY in the first quarter. The company's performance in Japan is being affected by Japan Tobacco's (OTCPK:JAPAF) aggressive investments and successes in recapturing its market share following 2011's natural disaster. In 2013, Japan Tobacco's market share surged to 60.5%, up 1% YoY. The company forecasts volumes for the Japanese Cigarette Industry to be down 3%-3.5% in 2014, as compared to a 2% drop in 2013. Philip Morris has planned to increase its sales and marketing expenditures in upcoming quarters, in a bid to at least sustain its 2013 market share level, while returning to growth over time. Also, the company is intending to channel investments towards its innovation plans, which will bode well for its market share.

The EU region has started displaying early signs of improvement, as the sales volume trend has started to moderate. The recent volume trend and the company's market share trend in the EU are both positive. In the first quarter of 2014, the company observed a market share gain of 0.9%, while its sales volume dropped 2.9%, outperforming the industry volume decline of 5.6% YoY. Going forward, increased efforts to prevent illicit trade and changes in the tax structure are the likely factors that will help volumes in the region.

Final Take

The company has a solid business model and its fundamentals remain intact. The company enjoys fat margins and holds dominant positions in various markets around the world. The stock is a good investment prospect for dividend-hunting investors, as it offers a safe dividend yield of 4.4%, backed by a free cash flow yield of 6.2% (free cash flow yield is based on full year 2013 numbers). However, the company has been facing headwinds in some of its key markets, mainly in Asia. The company has plans to direct investments in efforts to stabilize its market share and compete efficiently in markets where its share is being challenged, which in my opinion will start showing signs of improvement in 2015 and onwards, if not in 2014.

Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Source: Philip Morris: Patience Is Required