Phillip Morris: Will Collateral Damage From Reynolds American Judgment Create Opportunity?

Jul.21.14 | About: Philip Morris (PM)

Summary

Reynolds American being hit with $23.6B in punitive damages should pull down all cigarette stocks in the week ahead, yet Phillip Morris is not exposed to the US legal/regulatory risks.

The cigarette industry is slowly declining, but the super-low cost of manufacturing cigarettes enables sustainably high ROICs across the industry and the customer base is extremely 'loyal.'.

PM in particular earns a fantastic 58.1% ROIC.

At 14.9x FY14 adjusted EPS guidance for 4-6% earnings growth and a 4.37% dividend yield, PM would be a clear buy for me without the legal/regulatory risks.

With the tough circumstances, I'd really feel comfortable paying 12x or ~$70. Doubt the stock will get there despite the negative catalyst, but I will continue to watch.

I did somewhat comprehensive research (note that the research was not published on Seeking Alpha or any other crowdsourced platform) on Lorillard (NYSE:LO) when the stock was just under $50 earlier this year. I really liked the company and stock at the time, but did not pull the trigger because I was concerned about regulatory and legal risks and acceleration in the industry's decline. Today, I read that Reynolds American (NYSE:RAI) was hit with $23.6B in punitive damages in a Florida lawsuit. It really got me thinking because:

  • It seems very excessive.
  • I don't think the judgment will hold up.
  • I don't think regulators or the legal system (in US and globally) will outlaw cigarettes completely now or in the next 5-10 years. It would be unjust in my opinion and mean losing lots of tax revenue.
  • I do think the stocks of all cigarette companies will take a beating that is largely unwarranted this upcoming week.

This could create an excellent buying opportunity, but the decision also makes me a bit concerned about cigarette companies exposed to the US. Phillip Morris International (NYSE:PM), with no US operations, struck me as the best of the bunch to check out. It isn't exposed to the US but is a US company owned by large US mutual funds that should take a beating alongside its peers.

Business

Phillip Morris International was wholly-owned by Altria Group (NYSE:MO) until it was spun off in early 2008. It is an everywhere-but-the-US cigarette company with the #1 or #2 market position in most of the 180 markets it occupies. Its leading brand is Marlboro (33% of sales). Other prominent brands are Merit, Parliament, and Virginia Slims, and the company is increasingly dependently on local cigarette brands.

I like that it is essentially a "Global minus the US" company. Economic growth is tough to predict but the global economy has been growing faster than the US and that should continue, which means that (Global - US) economic growth will be even better than both global growth and US growth.

I like that the company has obvious customer loyalty, albeit for the wrong reasons (addiction). Fewer people are beginning to smoke, but the existing base should offer predictable/recurring demand for some time. The product is also very intangible, similar to a can of Coke (NYSE:KO). Anyone who has smoked a cigarette and enjoys the sensation it provides will agree that it provides far more utility in dollars than the few cents it costs to manufacture.

I like that the secular decline in cigarette demand has been predictable at 1-2% annually, 1.4% in 2013, but declining market share for Phillip Morris is concerning and makes the company's top line performance far less predictable than it should be:

Our total cigarette shipments decreased 5.1% in 2013 to 880.2 billion units. We estimate that international cigarette market shipments were approximately 5.6 trillion units in2013, a 1.4% decrease over 2012. We estimate that our reported share of the international cigarette market (which is defined as worldwide cigarette volume excluding the United States of America) was approximately 15.7% in 2013, 16.3% in 2012.

The regulatory and legal risks I mentioned are very concerning, but I think if I found a really compelling value I would still be open to investing. In other words, the industry decline and the risks are very close to being deal-breakers for me, but not quite.

I think Phillip Morris and cigarette companies in general are outstanding businesses, run to create value, and benefitting from an irresistible product.

ROIC

Return on invested capital is the best quantitative measure of business quality in my view. I calculated it as:

EBIT(1-t) / (Total Assets - Goodwill - Excess Cash - Current Liabilities + ST Debt)

Based on the company's cash balance going from $3.981B last year to $1.823B at the end of Q2 this year, I assumed $2B of cash included in working capital and in turn $1.981B in excess cash.

I calculated 58.1% which is excellent - far above the 8-10% average. This is probably sustainable too considering how little it costs to manufacture a cigarette.

Valuation

Since being spun off by Altria 7.5 years ago, PM has grown at the following CAGRs:

  • EBIT 4.8%
  • FCF 8.5%
  • Revenue 5.2%
  • EBITDA 4.1%
  • Dividend 10%
  • EPS 7.7%

The company has had operational troubles of late, but I think 4-6% per share growth is reasonable going forward. In general, for a 4-6% grower with a 4.37% dividend yield and sustainably fantastic ROIC, I'd be willing to pay 20x or so. PM currently trades for 14.9x FY14 adjusted EPS guidance, 16.3x LTM FCF, and 12.92x EV/EBIT. That's well below my 20x, but I was honestly hoping for a little more considering the risks involved. Obviously this valuation is very arbitrary, but I need to be very comfortable with the price I am paying relative to what I am getting and here I'd feel comfortable paying about 12x adjusted EPS or about $70.

Conclusion

Absent the regulatory and legal risks, I think Phillip Morris stock is an obvious buy right now, but I don't like the idea of paying so close to an average multiple (15x) for well-above average risks. That said, I most definitely expect shares to take a significant hit this week due to the Reynolds American legal judgment announced today. I seriously doubt shares will get to where I'd really like them at $70 considering the stock has not been there in over 2 years, but even if it gets close I will consider performing deeper due diligence. I am still very much interested, but am not investing at this point.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in PM, LO over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.