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Summary

  • Solid performance signals improvement for company across key markets.
  • Price increases will remain important future top-line growth driver.
  • PM could experience earnings pressures in short term due to rollout of Marlboro 2.0 and spending on next generational products.

As tobacco stocks offer attractive dividends, they have remained the preferred choice among dividend investors. Tobacco companies have done well to expand their margins and dividends in recent years. However, higher taxes, tougher regulations, higher health awareness and increasing popularity of alternate tobacco products have negatively affected the sales volume of the Tobacco Industry. Due to the challenges faced to increase sales volume, companies are relying on price increases to expand their top-line numbers. Philip Morris (NYSE:PM), the world's leading tobacco company, has been delivering a decent financial performance in the recent past despite the challenges. The company recently reported solid 2Q14 financial results, which I believe are indication for an improvement in the operational environment. Also, the company has been effectively addressing the challenges it faces in several markets. Moreover, the company's attractive dividend yield of 4.10% and potential price appreciation of ­­­18% make it a good investment option for investors.

PM reported a solid financial performance for 2Q14. The company reported EPS of $1.40 for 2Q14, beating consensus estimates of $1.2 per share. Also, the company reported solid revenues for the quarter of $7.79 billion, better than consensus estimates of $7.5 billion. Sales volume for the company dropped by only 2.7% year-on-year in the quarter, and to offset the impact of sales volume decline, the company increased prices by more than 6%. I believe the earnings beat is of high quality, as it was driven by solid top-line numbers and margin improvement; operating margin increased by 90 basis points in 2Q14.

A positive takeaway from the recent quarter's earnings release was the improvement in the European Union [EU] market for the company. The EU has been an important market for the company; in the recent past, the company experienced a high sales volume decline. However, since the last two quarters, the EU has started to deliver better results, which indicates a turnaround in the market. Improving economic conditions and lower acceptance of alternate tobacco products in the EU are likely to portend well for the company's sales volume and stock in the future. In 2Q14, the company experienced an adjusted sales volume decline of 2.4%, better than the company's guidance range of -5% to -7%. Also, the company's market share for the EU increased by 0.90% in 2Q14. If the company continues to experience sales volume growth better than the guidance range of -5 to -7% and continues to increase pricing, it will positively affect PM's margins. Also, the company's price increases in Germany, Spain and Portugal will positively affect the top-line numbers of the segment. However, the price repositioning of Chesterfield and the absorption of VAT in Italy could pressurize the EU profitability in the near term.

Other than the EU, the company's EEMEA segment also delivered strong results for 2Q14, mainly driven by 15% price increases, which resulted in operating profit growth of 28.8% (excluding currency) year-on-year. The strong profit growth for EEMEA in 2Q14 will help address investor concerns that weak volumes would adversely affect the company's bottom-line numbers. In 2Q14, sales volumes for EEMEA were down 2.8% year-on-year.

The company continues to face challenges in Asian markets, mainly in Japan and Philippines. Sales volumes for the company in Asia were down 6.1% year-on-year in 2Q14. Increase in taxes and competitive pressures have adversely affected the company's performance in Japan and resulted in sales volumes decline of 2.8% year-to-date. The company needs to increase its competitive activities in Japan to stabilize its market share and support sales volume. I believe once the company increases its competitive activities, it will be able to stabilize its market share and moderate sales volume decline, which will portend well for the company in the long term. A positive takeaway from the Asia segment was the fact that the company in 2Q14 enjoyed sales volume growth of 1.3% in Indonesia, which is an important market for the company due to its large population and customer base. Also, the company is expecting the Indonesian market to grow by 1% in 2014, as compared to a 1.9% drop in 2013.

The strong recent quarter's results indicate an improvement across major markets for PM. However, the rollout of Marlboro 2.0 and spending on next generation products could pressurize the company's results in the near future, but the initiatives will positively affect the market position and performance in the long term.

Risks
A shift in consumer preference towards smoke-less tobacco products and tougher regulations have adversely affected the sales volumes of traditional cigarettes. A consistent sales volumes decline poses a risk to top-line growth and PM has to consistently increase prices to offset the volume decline. Also, as the company has large international market exposure, strengthening of the U.S. Dollar remains a risk to the top and bottom-line growths of the company. The company is anticipating $0.61 per share of foreign currency headwinds to its 2014 EPS.

Conclusion

The company reported a high-quality earnings beat for 2Q14 and I believe the solid performance for the quarter signals an improvement for the company across its key markets. Also, I believe price increases will remain an important top-line growth driver for the company in the future. The company could experience earnings pressures in the short term due to the rollout of Marlboro 2.0 and spending on next generational products. However, the initiatives will portend well for the stock price in the long term.

I believe the stock valuations remain attractive, as it is trading at a forward P/E of 15.25x, as compared to the S&P 500 forward P/E of 16.45x. Moreover, the stock offers a potential price appreciation of 18%, based on my price target of $101. I calculated my price target of $101, using the 2015 EPS estimate of $5.61 and the S&P 500's forward P/E of16.45x. (I applied a 10% premium to the S&P 500 forward P/E of 16.45x due to the company's large international market exposure.)

S&P 500 Forward P/E

2015 EPS Estimate

Price Target

16.45x*1.10 = 18x

$5.61

$101

Source: Philip Morris: Making Correct Moves