Is Philip Morris About To Slump?

| About: Philip Morris (PM)

Summary

Philip Morris’s earnings are set to be hurt by negative currency effects.

While this is a risk to its earnings, we think that Philip Morris has tremendous pricing potential which will more than offset negative currency effects.

We also think that reduced risk product (RRP) development and a low valuation will act as further positive catalysts on its share price moving forward.

We're bullish on the prospects for the global economy, but one risk which international companies such as Philip Morris (NYSE:PM) faces is a strengthening US dollar. This may seem counterintuitive given the fact that the market was anticipating four interest rate rises in 2016, but is now expecting just one in the next twelve months.

However, with the EU, UK, Japan and other parts of the world intent on adopting further stimulus measures over the coming months, the reality is that the US dollar is expected to strengthen against a basket of key currencies including the euro, yen, sterling and the Australian dollar.

This is a key concern for investors in Philip Morris, since all of its sales are derived from outside of the US and will therefore be negatively affected by a strengthening dollar. Therefore, many investors may feel that Philip Morris is about to endure a challenging period which could see its share price fall. After all, the negative currency impact on earnings in Q2 was $0.08 per share.

However, we think that there are three catalysts which will not only offset the effects of a strengthening dollar on Philip Morris' share price, but will cause the company's valuation to rise at a faster pace than the wider index moving forward.

The first catalyst is pricing improvements. With Philip Morris owning Marlboro, the dominant global brand in cigarettes, we feel that there is vast scope for price increases which will more than offset the potential negative currency impact of a strengthening dollar. For example, Marlboro was the 10th biggest brand in the world in 2015, with it being valued 19% higher than in 2014 at $80 billion.

Further, Philip Morris owns the world's 3rd biggest selling brand, L&M, and when the customer loyalty of this is added to that of Marlboro as well as the company's other brands (it owns six of the world's 15 biggest cigarette brands), it indicates that there is a high degree of customer loyalty present in our view. And with tobacco having a negative price elasticity of demand, the pricing potential is exceptionally high in our view. As such, we think that this will be a key catalyst in boosting Philip Morris' earnings and share price moving forward.

The second catalyst which we think will push Philip Morris' share price higher is its capabilities within the reduced risk product (RRP) space. Sure, other tobacco companies such as Reynolds (NYSE:RAI) and Japan Tobacco (OTCPK:JAPAY) are investing in e-cigarettes and thus far it has been a growing market for them. However, we feel that Philip Morris is in a stronger position than its rivals to develop RRPs, since it has greater financial firepower in this space, thanks to its agreement to develop RRPs with Altria (NYSE:MO).

The deal means that the two companies will work together on RRPs and with them operating in different geographies, they seem to get the best of both worlds. In other words, they benefit from reduced investment risk of a partnership without the friction of being rivals chasing the same sales. And with Philip Morris and Altria already having introduced a new breed of RRPs in the form of Marlboro Heat Sticks which heat rather than burn tobacco and reached a national share of 2.2% in Japan in Q2, we think that the two companies are in an excellent position to develop further RRPs moving forward. As such, in our view this partnership on RRPs will positively impact on Philip Morris' earnings and valuation.

The third catalyst which we think will cause Philip Morris' share price to rise is its dividend appeal. It currently yields 4.1% versus 3.3% for Altria and 3.4% for British American Tobacco (NYSEMKT:BTI). In our view, this indicates that Philip Morris' higher risk from negative currency impacts over the next year is more than adequately priced in, since its shares could rise by over 20% and still yield the same as those of British American Tobacco.

In our view, this price discrepancy between Philip Morris and two of its sector peers is too wide and will narrow moving forward. In fact, with the US dollar expected to strengthen by less than 3% versus the euro in the next year, we think that the overall impact of a strengthening US dollar has been overplayed in Philip Morris' valuation. Therefore, we think that investors will see Philip Morris as a value play relative to its tobacco peers moving forward, with this improved investor sentiment acting as a positive catalyst on its share price.

Clearly, being exposed solely to non-US markets means that Philip Morris is affected by the impact of currency translation. While this is expected to be negative in the next year, we think that the company's low relative valuation, pricing potential and the appeal of its RRP development will act as positive catalysts on its share price and allow it to continue beating the S&P moving forward.

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Disclosure: I am/we are long BTI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.