One of the leading tobacco companies of the world, Philip Morris (NYSE:PM), has remained a popular investment prospect for income-seeking investors. Philip Morris' business fundamentals stay strong and intact as the company generates strong cash flows, and has stable dividends and fat margins. The company's large geographical diversification remains an important growth catalyst, as it has exposure to both developed markets (which offer high margins) and emerging markets (which offer growth). Also, cost cut initiatives and product innovation are likely to augur well for the company's growth in upcoming years. Nevertheless, in recent quarters, stock valuations have been under stress because of weak volume growth and currency headwinds. The increasing popularity of alternate tobacco products, rising health awareness and sturdy regulations have been challenging volume growth of the global Tobacco industry, including Philip Morris.
In recent quarters, the company's performance has been challenged in several of its markets, either because of sturdy regulations, competition or currency headwinds. The company has been facing issues in some Asian markets, whereas its performance in the EU and EEMA regions stays healthy.
In an attempt to address competition and strengthen its product portfolio and market share, the company has been taking initiatives, which will bode well for its performance in the medium to long term, however, margins could be challenged due to the increased initiatives. The company's margins and profitability are expected to remain slightly weak in the second half of 2014 versus the first half because of a challenging quarterly comparison, the investment behind "Reduced Risk Products" (iQOS), the rollout of Marlboro Red 2.0 and costs related to manufacturing footprint optimization. 
Source: Investors Presentation
Asia
Asia was once considered the key growth region for the company. However, in the recent past, the soft performance of the Asian region has weighed on the overall growth of the company. Japan, an important Asian market, is one of the largest tobacco markets of the world, with a global volume contribution of almost 6%. Volumes in Japan have been on a decline because of regulations and tax increases; Cigarette industry volume declined by 3% YTD.
Philip Morris has a significant market share of 25.8% in Japan. However, the company's market share has been negatively affected in the recent past, as Japan Tobacco ramped up its initiatives to regain its market share following the earthquake in 2011. Japan Tobacco continues to regain market share, which increased to 60.5%, up 1%, in 2013, beating PM's market share. Philip Morris expects its volumes to be down 3%-3.5% in 2014, as compared to down 2% in 2013. In an attempt to address competition and sustain its market share, Philip Morris has plans to increase its sales and marketing spending in Japan to support aggressive innovation plans. In the short term, the company will continue to face competitive pressure in Japan; however, in upcoming years, the company's growth spending will augur well for its market share and profitability in Japan.
Another important market for Philip Morris is Indonesia, which contributes almost 10% to the company's operating profit. In recent years, Philip Morris' growth prospects were negatively affected by competition, a decrease in government subsidies and an increase in core food inflation. In addition, tax structure reforms in the country positively affected small cigarette companies, which fueled competition in the industry. However, lately, the Indonesian tobacco market has started to display signs of improvements. The Indonesian Cigarette industry's volume increased 1.4% YTD, and PM's market share has started to improve since recent quarters. The company expects the Indonesian market share to be up 1% in 2014, versus a 1.9% drop in 2013. Also, the company has started to experience a modest increase in market share in the country, as reflected below in the table. The company is expected to benefit in the future from investments behind product innovation and address competition, which will restore investor confidence.
Q4 2013 | Q1 2014 | Q2 2014 | July 2014 | |
Philip Morris Market Share In Indonesia | 35.7% | 34.6% | 34.9% | 35.1% |
Source: Investors Presentation
The company's Australian market dynamics stay challenging, primarily because of strict regulations, including exports difficulties. Also, the company is closing its manufacturing facility in Australia as a result of higher production costs and strict regulations. The company plans to shift production from Australia to South Korea. Also, it has been making investments behind the "Bond Street" brand, which will drive market share recovery, but will bring profitability under stress. The strategic changes that the company has opted for in Australia are likely to put pressure on its volumes and margins.
EU and EEMA
The performance of Philip Morris in the EU stayed strong in the first half of 2014 due to moderation in the Cigarette industry volume decline; as volumes were down 3.2% YTD July 2014, as compared to the recent years' average volume decline of 5% to 7%. The EU industry trend has been improving because of a reduction in illicit trade, less out-switching to fine-cut products, slowdown in the growth of e-vapor products and favorable trade inventory movements. In the future, efforts to prevent illicit trade and price increases will positively affect the region's volumes and earnings growth.
The performance of the EEMA region has stayed strong as Philip Morris enjoyed profit growth, despite a decrease in volumes. The company's performance in the EEMA region is primarily driven by price increases. Despite the sales volume decline of almost 3% in the second quarter of 2014 for the company in the region, revenues and operating profit were up 4.7% and 15%, respectively, in the quarters.
Final Words
The company's performance in some of the Asian markets remained challenging in the first half of 2014. However, it has been undertaking initiatives to strengthen its market share in Asia and product portfolio, which will augur well for the region's growth in the long term. On the other hand, Phillip Morris' performance in the EU and EEMA has started to show signs of improvement, which will increase investor confidence in the company's future earnings potential. In my opinion, the company needs to deliver consistent improvements across its operating regions, which will result in stock valuation expansion. The stock is currently trading at a discount to large-cap consumer companies with significant international market exposure, as displayed in the table below. Also, the stock's attractive valuation and high dividend yield of 4.6% protects the downside of the stock price.
Philip Morris | Colgate (CL) | Mondelez (MDLZ) | PepsiCo (PEP) | Procter & Gamble (PG) | |
Forward P/E | 15x | 19.5x | 17.3x | 18.5x | 17.3x |
Source: Yahoo Finance
