Philip Morris (PM) broke off from Altria in 2008 to separate the domestic tobacco business (Altria) from the international. Philip Morris operates in four main markets: Europe, Eastern Europe/Africa/Middle East (EEAM), Latin America/Canada (LAC), and Asia. The European market has been declining especially in areas struck by the debt crisis. EEAM and LAC (Mexico down, but Argentina and Canada up) have been relatively stagnant.
However, when we move to Asia we arrive at one of our catalysts:
1. Business In Asia Net volume between in Asia grew over 10% the past year and nearly 25% the year before. Operating income grew 60% and 25% in 2011 and 2010 respectively. Growth in this area is particularly beneficial because the main costs this company experiences are excise taxes on cigarettes. Although it is difficult to determine what the actual excise tax is, excise taxes represent 68.7%, 54.7%, and 65.5% of net revenues in Europe, EEAM, and LAC, whereas in Asia only 45.4% of net revenue. Thus, the company can have a stagnant volume but still increase there profits if the trend of increased business in Asia continues. I believe it will continue to grow for 2 primary reasons: the debt crisis has not struck the Asian markets like it has the European markets, which has caused the decline, and more significantly, PM has not achieved the market penetration it has in the other 3 markets and thus still has room to grow.
This increase in margin is complimented by the changing tastes of consumers and Marlboro's pricing power. Marlboro is the flagship brand of PM. This is considered a premium cigarette. PM also offers low price and mid price cigarettes.
This leads us to the second catalyst:
2. Improved Mix and Pricing Power - Marlboro remained steady growing about 1% in volume internationally over the past year. However, the biggest growers over the past year have been Parliament (Premium 12.1%), Lark (Leading International, 17.5%). Although the economic climate is shaky it is improving which should help this force. Additionally, cigarettes in many places remain a status symbol providing more reason to trade up. This may aided by PM's ability to raise prices as taxes go higher because cigarettes are relatively inelastic. The combination of these elements is evidenced by the fact that out of the positive elements that summed to $1.10 in EPS growth, before negative items reduced it to $0.93, $0.62 of the positive growth was generated by a combination of PM's ability to sell all cigarettes at higher prices and to sell a higher proportion of premium cigarettes.
3. Cash Generation And Use Of Cash - PM is extremely good at generating cash for a company whose top line revenue growth is not strong. Coming out of the recession, PM has continued to increase its cash flow from operation from $7.88B to $9.44B and $10.53B from 2009 to 2011. In 2011, they used $4.8B to pay dividends (currently yielding 3.61%) and about $5.3B to repurchase stock. The dividend can serve as a catalyst because they have consistently increased their dividend so that payments are about 50% of net income. They are planning on using $6B to repurchase shares this year which will have the effect of holding up the price of the company and increasing EPS. At the same time it indicates the company's confidence in the value of the company. They will continue to produce cash given their ability to grow net income. This is supported by catalyst one as well as PM's commitment to cutting costs. They pledged to cut costs $250MM last year and were able to do so; they have made the same pledge this year. Their strong cash generation also allows them to service their debt which is evenly spaced out over the coming years can be financed at lower and lower rates given PM's credit worthiness.
There definitely are risks to the thesis. A poor economic climate will hurt both volume and mix figures for PM; however, poor economic conditions will affect all companies. A greater risk comes in the form of legislation in countries. This can include smoking bans in public areas, warning labels on packaging and making all cigarette packaging identical. The last two are the most serious. Warning labels may make cigarettes less appealing while identical packaging eliminates arguably PM's greatest asset, its brand name in the form of Marlboro and others. This may also have the added effect of making counterfeiting easier which is also a significant problem to PM. However, this is where PM is a better play than other cigarette manufacturers. PM does their business in areas where smoking is generally more accepted and legislation has not been as tough upon tobacco manufacturers. Additionally, PM has a strong history of lobbying preventing any major changes that will materially affect the business over the short term.
Currency is another risk. They have had some swings in earnings due to currency and a continued strengthening of the dollar in light of sovereign debt troubles is not beneficial. However they do hedge making these movements relatively small in the big picture. A fake risk is litigation. Since 1995 there have been 376 cases against PM; only 10 have resulted in a win for the plaintiff, and six were successfully appealed.
Philip Morris is trading at a slight premium to competitors; I believe this premium is more than worthwhile. I see this company in addition to the aforementioned catalysts being a strong company with a relatively limited downside risk, a strong dividend payment, and exposure to inelastic consumers for one's portfolio.