Philip Morris: Inelastic Demand of Tobacco Is Your Protection Against Inflation

Jan.19.11 | About: Philip Morris (PM)

Many authors and commenters here at Seeking Alpha (as well as at many other financial sites) have expressed unease about the current monetary policy of the Federal Reserve. Their major concern is that the second round of quantitative easing, which shows little sign of slowing down, will lead to inflation.

Indeed, many analysts on Wall Street appear to share the same view. On a fundamental basis, these fears are quite well founded; as a greater supply of money chases the same amount of goods and services, prices must necessarily rise.

As investors, there is little that any of us can do to influence either fiscal or monetary policy. Therefore, our greater concern should be finding ways to protect our portfolios from this coming inflation and even grow our wealth in the face of it. One way to do this is by investing in companies whose products have inelastic demand.

Inelastic demand is a condition in which the price of a given good will not significantly affect the quantity of those goods demanded. More broadly, a company whose products have inelastic demand has pricing power. It can increase its prices with inflation and not lose business. An investor who expects inflation would be well-served by having a portion of their portfolio in a business like this.

Philip Morris International (NYSE: PM) is an excellent example of a company whose products have inelastic demand. This is an international tobacco company based in Lausanne, Switzerland (and still maintaining a significant presence in New York, New York) that has no sales in the United States. Tobacco is an addictive product with very high brand loyalty. It is difficult to imagine a more inelastic product than that! Philip Morris International owns seven of the top fifteen worldwide cigarette brands and holds a 15.6% share of the worldwide (ex-USA) cigarette market. Due to the market dominance of its products and the addictive qualities of cigarettes, the company has an incredible amount of pricing power. This is a very desirable quality for an investor seeking protection against inflation.

At the time of this writing, PM trades with a trailing P/E of 15.10 and a trailing Price/Cash Flow of 12.90. This is hardly a value play, especially considering its 1.6 PEG ratio. The 2010 analyst consensus earnings are $3.87, which gives PM a P/E of 14.64 at its current price. The 2011 analyst consensus is $4.35/share. That estimate gives PM a forward P/E of 13.02. This valuation is not cheap, but it is not out of line with the rest of the market. The valuation is on the rich side for a tobacco company, but for reasons that will be discussed later in this article; I believe that the valuation is justified.

Philip Morris International has an agreement in place with the China National Tobacco Company for the licensed production of Marlboros in China. This is an incredible growth opportunity for PM. The smoking rate among adult males in China is 67%, according to the World Health Organization. Marlboro has the status of a premium or aspirational brand of cigarette in China. Therefore, look forward to this very large population of smokers to migrate over to Marlboro cigarettes as the Chinese middle class continues to grow and become wealthier.

PM has a forward dividend of $2.56/share. At the current price, that gives PM a dividend yield of 4.52% with a payout ratio of 63.30%. The former parent of Philip Morris International, Altria Group (NYSE: MO), was dedicated to consistently increasing the dividend year over year and that is a trait that management kept when they came over to PM. PM has increased its dividend by an average of 13.85% since its spinoff from Altria Group in 2008. I expect that PM will continue its annual dividend increases by an average of 10% going forward. This dividend and dividend growth rate (both of which are greater than the respective figures for the S&P500) helps to make that valuation much more palatable.

The most significant negative financial factor about Philip Morris International is its somewhat high amount of leverage. According to the company’s latest 10Q, it currently carries $17.044B in long term liabilities and $4.532B in shareowners’ equity. This gives it a debt to equity ratio of nearly 300% (It is worth noting that this is the average over the past twelve months as stated by several financial databases. I calculate the current debt to equity ratio as 376% - the value is increasing due to a large share buyback program).

PM is an extremely profitable company however, and generates more than enough free cash flow to handle this debt and pay out its sizable dividend. The return earned on this leverage is even more impressive. According to Fidelity, the TTM return on equity is 146.52%. Yahoo! Finance pegs it a little lower, at a still impressive 129.31%. The high debt does not appear to be a problem at this time but should some unforeseen circumstance significantly reduce the cash flows, then it could become a problem. This is not likely to happen, however.

In conclusion, Philip Morris International offers some of the best qualities available to an investor that is looking to protect against inflation. It is extremely profitable with a product that has highly inelastic demand, it has a high dividend with the likelihood of future growth, it conducts all of its business outside of the United States (and so is a hedge against a declining dollar), and it offers the potential to continue to grow its business.

Disclosure: I am long PM.