Since announcing an $18B share repurchase program, Philip Morris International (PM) has appreciated by 2.7%, meaningfully, but not incredibly, outperforming the S&P 500 by more than 230 basis points. Even though I would have anticipated higher returns as a result of the announcement, the repurchase program makes me more confident about the fundamentals. Tobacco firms are noted for their dividend yields (Philip Morris' stands at 3.5%) and low volatility. In my view, Altria (MO), Philip Morris and Reynolds American (RAI) are all well-positioned to outperform broader indices over the next three years while providing high dividend yields.
Philip Morris may appear expensive, trading at 17.4x past earnings, but it (like its tobacco peers) is a free cash flow machine. It has dramatically grown free cash flow from around $7.2B in FY2009 to north of $9.6B in FY2011. My DCF model starts at a base of $9B in 2012 and projects $15.8B by 2017. These results are yielded through several assumptions: (1) 12% per annum growth over the next six years and (2) operating metrics stay at historical levels. If I factor in a 2.5% perpetual growth rate and 8.5% weighted average cost of capital, I find the intrinsic value of the stock to be nearly $120. This WACC is justified, given the firm's high dividend yield and low beta. My intrinsic value is at a more than 35% premium to the market value, and comes on top of the 3.5% dividend yield. Only if the company were to grow perpetually at 2% and have a WACC of 10% would the current value be justified, given past performance.
Of course, past performance is not a solid indicator of future performance, but tobacco companies are stable and, if anything, Philip Morris International has more room for market penetration. The Marlboro marketer was spun off from Altria a few years ago in order to specifically target demographics outside of the United States. The strategy appears to have paid dividends, with the stock up more than 77% since being spun off; for context, the S&P 500 was flat over the same time period.
Altria and Reynolds offer even higher dividend yields at 4.9% and 5.6%, respectively. They are also slightly more expensive than Philip Morris on a PE multiple basis. With that said, they are also free cash flow champions. Reynolds and Altria have failed to achieve the same momentum in free cash flow growth as Philip Morris has over the last three years, but the results have still been strong. In fact, since the Philip Morris spin-off, Altria and Reynolds have appreciated by 35.6% and 52.3%, respectively. Again, this does not include the high dividend yields and was at a time when the S&P 500 was flat.
In total, what you have with tobacco is stability and value. While low betas and shareholder friendly capital allocation policies mitigate risk, penetration is going nowhere but up. Tobacco purchasers tend to stay loyal consumers; the trick is just to get more of those loyal customers. I am attracted to Philip Morris' international quest but, from a value perspective, I believe that investors are exaggerating Reynolds and Altria's political risk in the United States. Yes, "Big Tobacco" will always be targeted for the next round of tax hikes, but this is already common knowledge, and has been factored into the stock prices. Graphic labels are unlikely to become a reality, especially in light of study after study indicating overblown risk perception towards smoking. Abnormally high stock returns will result as the fundamentals continue to defy concerns about regulation and taxes.
Ironically, one area of tax policy in regard to tobacco that has not gotten enough attention is entirely separate from operations: dividend taxes. If the Obama administration is successful in categorizing the top dividend tax rate at nearly 40%, it is axiomatic that stock prices will fall. It is axiomatic, because the stock market justifies a certain after-tax dividend yield, and if this figure falls, the stock price must fall accordingly to realize the same initial after-tax dividend yield. Donald Luskin, author of the above link, believes that stock prices may fall as much as 30% from the tax policy. Of course, this tax will not just have deleterious effects for tobacco shareholders but also utilities shareholders. And of course, some (but not all) of the tax risk has been factored into the stock price. Because I do not believe that dividend, income, or corporate taxes will be hiked, I actually expect these risks to drive higher returns as reality kicks in.
Disclaimer: 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
