Don't Lose Hope On Philip Morris

| About: Philip Morris (PM)
This article is now exclusive for PRO subscribers.

Philip Morris International (PM) profits fell 8.3% year over year due to declining sales in the Asian and European regions. Despite the decrease in profits, the company recently announced an 11% rise in dividend, which was $0.85 in the earlier quarter. It has also engaged in a three-year share buyback program worth $18 billion that the board approved in June 2012. The company has spent $5.9 billion in share repurchase since the approval, which means it still has a hefty amount left under the repurchase authorization.

Acquisition to make presence stronger

Recently, Philip Morris acquired a 25% stake in a tobacco manufacturer, "Societe des Tabacs Algero-Emiratie", or STEAM, for $625 million to expand in Africa. This acquisition will also help Philip Morris attain a 49% stake in UAE based 'Arab Investors TA', or AITA, which owns 51% of the STEAM venture. Philip Morris has been in partnership with STEAM since 2005 for manufacturing and distributing its Marlboro and L&M brand.

Together with STEAM, Philip Morris is amongst the cigarette leaders in Algeria, its brands are the second largest in the market. We believe the acquisition will allow Philip Morris to build a stronger presence in Algeria, and it is expected to be accretive to its earnings from fiscal year 2014. In our view, this is a strong opportunity for Philip Morris as the cigarette sales volume is anticipated to grow at a CAGR of 4% from 2011 to 2016 in Algeria. A rise in the smoking population, with an increase in the number of female and young smokers, is one of the reasons for the growth in cigarette sales.

Algeria has the fourth largest total GDP in Africa and an estimated cigarette market of 30 billion units, which provides the company with excellent potential for growth from the next year onwards. The Eastern Europe, Middle East, and Africa, or EEMA, segment contributes more than 26% to the company's total revenue. We expect the deal to escalate the revenue coming for the EEMA segment and also stabilize the sale of its best-selling brand Marlboro, which declined 5.4% year over year in the first half of 2013. Moreover, the partnership with AITA will also bring business opportunities from Egypt and few other North African and Middle Eastern markets.

In addition to the acquisition in Africa, Philip Morris acquired the remaining 20% stake in its joint venture Philip Morris Mexico for around $700 million from its partner Grupo Carso (OTCPK:GPOVY). It completed this acquisition on September 30, 2013, and now Philip Morris has 100% ownership of the Mexican business. We expect the deals in Algeria and Mexico will guide it to penetrate growing markets faster and improve its sales volume.

Exploring new product

With the help of the acquisition discussed above, Philip Morris will also try to negate the effects from the stringent regulatory environment for tobacco products. The European Union, or EU, which contributes more than 35% of the company's total revenue is under pressure and might observe a decline in sales volume. The EU members recently approved to initiate a new anti-tobacco law, which demands a minimum of 65% of the cigarette pack surface area to be utilized for health warnings. The EU members are also planning to raise the excise taxes on tobacco products in Europe. According to the current tax policy, Philip Morris has to pay a minimum $84 per 1,000 cigarettes, but beginning in January 1, 2014, it will have to pay minimum a $122 per 1,000 cigarettes. We believe these factors will result in margin decline, and Philip Morris will have to rise the per pack price, which could hamper sales volume in Europe.

In our view, Philip Morris' plan to launch e-cigarettes by 2016-2017 will negate the effects from the stringent regulatory actions. According to the company, the new e-cigarettes have a controlled heating mechanism that will heat tobacco or an aerosol nicotine-delivery system. This will maintain the original taste of the conventional cigarette, which isn't available from the e-cigarettes currently sold in the market. The company purchased the rights to a technology that lets users inhale nicotine without smoking in 2011, and it is developing several other next-generation products. The e-cigarette market is expected to reach $2 billion this year and may touch the $10 billion mark through 2017.

Moreover, all e-cigarettes will have to be licensed as medicines under regulations that are set to be introduced by 2016. This will give the company an easy access in the e-cigarette space. Through the licensing, consumers will also be more confident about e-cigarettes, for it is less harmful than conventional cigarettes. We believe this will boost the revenue coming from the European region and force it launch e-cigarettes to gain maximum market share.

Rising competition in the e-cigarette space

British American Tobacco (BTI) is a competitor also eyeing the e-cigarette market growth and is launching various products to capitalize on the opportunity. In July this year, it launched a new e-cigarette called "Vype" in the U.K., and it is the first company to launch an e-cigarette in the U.K. Initially, Vype was introduced online, but last week it was made available across all retail outlets in the U.K. British American Tobacco launched the disposable format of Vype, but it plans to release the rechargeable version in the coming quarters. The company also plans to launch the brand in multiple countries due to the growing demand for e-cigarettes. British American Tobacco has an excellent opportunity; last year an estimated 700,000 consumers used e-cigarettes in the U.K., which is forecasted to nearly double to 1.3 million during this year. Vype has been gaining popularity amongst the U.K. consumers, and we believe it will allow the company to observe revenue growth in the years to come.

(Click to enlarge)


Philip Morris will also face competition from Imperial Tobacco Group (ITYBY.PK), which plans to launch an e-cigarette next year. The company's announcement came after it posted 7% and 3% year-over-year decline in the volume and revenue respectively for the nine months ending June 30, 2013. Along with the launch, Imperial Tobacco also plans to buy Dragonite International's (OTC:DGTLF) e-cigarette business for $75 million. Dragonite is one of the best electronic cigarette companies and claims that it invented the electronic cigarette. The acquisition will give Imperial Tobacco an edge over its peers in the e-cigarette space through the expertise Dragonite has gained. Imperial Tobacco is the dominant player in the U.K. cigarette market with 45% market share. Through the new product and acquisition, we believe Imperial Tobacco has the potential to maintain its dominance and sustain its strong presence in the U.K. market. Moreover, this will reverse the revenue decline it has experienced in the next two years.


Philip Morris, through its acquisition and new product launch, has the potential to grow in terms of revenue. Despite its peers' new products in the e-cigarette market, we believe the company's dominance in the world is safe. Comparing it to the cigarette industry, the company is undervalued; the P/E ratio for the industry is 18.7 and the company has a P/E ratio of 17.05. Also, Philip Morris is known for treating its shareholders nicely, and we expect this to continue in the upcoming years. Philip Morris' initiatives will take the stock price beyond its current trading level, which will result in healthy returns to its shareholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. Fusion Research is a team of equity analysts. This article was written by one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.