Tobacco companies offer some of the strongest risk/reward. As they target emerging markets and lock in inelastic demand, investors will have both sustainable and high-growth streams of free cash flow to count on in future lees. In this article, I will run you through my DCF model on Lorillard (LO) and then triangulate the result with a review of the fundamentals against Philip Morris International (PM) and Altria (MO). I find that these companies are all meaningfully undervalued.
First, let's begin with an assumption about the top-line. The Newport marketer delivered $6.4B in revenue in FY2011, which represented a 9% gain off of the preceding year. I model 11.2% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 64% of revenue versus 6.8% for SG&A, 5.1% for R&D, and 0.75% for capex. Taxes are estimated at 37% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I model this figure hovering around -0.1% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $172.21, implying nearly 30% upside. This is on top of a 4.7% dividend yield!
All of this, however, falls within the context of disappointing performance:
"Our reported results, unfortunately, didn't reflect the continued strength of our underlying fundamentals, which remain intact. This is because the first quarter reported results were masked by a very significant comparative reduction in wholesale inventory. This negative comparison adversely affected our reported volume by over 400 million units or 4.3 percentage points in the quarter. Generally, 400 million full revenue units would have contributed about $34 million in operating profit, which would translate to $0.16 per share, and that would have translated to a level of EPS growth I expect from the business instead of the 1.8% adjusted EPS growth we reported. Absent that inventory comparison, which was primarily a timing issue, our business performance was consistent with the positive trends we saw last year".
Even still, the stock remains overly cheap. It trades at a respective 16.6x and 13.8x past and forward earnings versus 19.4x and 13.7x for Altria and 17.7x and 15.2x for Philip Morris.
Consensus estimates for Altria's EPS forecast that it will grow by 7.8% to $2.21 in 2012 and then by 6.8% and 6.4% in the following two years. Assuming a multiple of 17.5x and a conservative 2013 EPS of $2.33, the stock would hit $40.78 for 25.7% upside. Altria offers a 5.1% dividend yield and has delivered strong execution with adjusted diluted EPS growth of 7.9% in 2011. Greater share repurchases have further reinforced management's confidence over free cash flow.
Philip Morris was spun off from Altria and focuses exclusively on markets outside of the United States. The greater weight towards emerging markets meaningfully reduces risks while allowing for abnormally high growth. In the fourth quarter, the company increased net revenues by 8.2% while increasing global share growth for the fourth consecutive year. If you are looking for a tobacco company with solid momentum, Philip Morris is thus an attractive investment.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.