By The Valuentum Team
Philip Morris's Investment Considerations
• Philip Morris (NYSE:PM) benefits from its exposure to faster-growing regions of the world, including Asia and EEMA. Still, it remains exposed to regulatory risk and excise price shocks that may impact demand for tobacco in certain countries. Currency fluctuations can pose stiff earnings headwinds at times.
• Pricing will be the main driver of Philip Morris's income growth. We like the company's ability to raise prices despite a challenging economic backdrop in several regions of the world. Productivity gains should help profits as well.
• Though industry volume trends began to improve in 2015, total volume continued to fall for Phillip Morris. The firm's pricing strength provided a boost to revenue, as pricing initiatives added ~$2.1 billion to the firm's top line in the year.
• For 2016, Philip Morris is expecting reported diluted earnings per share guidance to be in a range of $4.25-$4.35 at prevailing exchange rates, compared to $4.42 in 2015. This guidance includes approximately 60 cents of unfavorable currency headwinds. Excluding these headwinds, the guidance represents a growth rate between 10%-12%.
• The firm's Marlboro brand continues its leading position in the EU region. The brand's share of the premium market in the EU has advanced steadily in recent years. In the EEMA region, its brand Parliament is gaining share in countries such as Kuwait, Kazakhstan and Turkey. The company's brand portfolio is solid.
• Regulatory risk continues to build for big tobacco. For example, lawmakers in the state of California, the most populous state in the US, have voted to raise the legal smoking age to 21 after Hawaii became the first state to do so in January 2016. Big tobacco had previously touted electronic cigarettes as a more healthy alternative, but these are also being targeted by regulators as additional health information is gleaned.
• Philip Morris has one of the most compelling dividend yields among its peers. Though its dividend safety metrics could be better, the firm's reliability gives us confidence in its ability to continue growing its payout.
Economic Profit Analysis
In our opinion. the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Philip Morris's 3-year historical return on invested capital (without goodwill) is 85.9%, which is above the estimate of its cost of capital of 9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Philip Morris's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 0.5 (anything above 1 is considered strong).
Though its Dividend Cushion ratio could be better, we think the reliability of its business warrants a good dividend safety rating. It's hard to go wrong with a tobacco-producing powerhouse, even as we say its debt load is worth watching closely.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Philip Morris' free cash flow margin has averaged about 25.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Philip Morris, cash flow from operations decreased about 18% from levels registered two years ago, while capital expenditures expanded about 9% over the same time period.
In 2015, Philip Morris reported cash flow from operations of ~$7.9 billion and capital expenditures of ~$1 billion, resulting in free cash flow of ~$6.9 billion, a ~5% increase from 2014.
This is the hottest portion of our analysis. Below we outline our valuation assumptions and light up a fair value estimate for shares.
Our discounted cash flow model indicates that Philip Morris's shares are worth between $61-$91 each. Shares are currently trading at ~$97, above the upper bound of our fair value range. This indicates we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $76 per share represents a price-to-earnings (P/E) ratio of about 15.9 times last year's earnings and an implied EV/EBITDA multiple of about 11.6 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 0.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -1.7%. Our model reflects a 5-year projected average operating margin of 40.8%, which is below Philip Morris's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Philip Morris, we use a 9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $76 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Philip Morris. We think the firm is attractive below $61 per share (the green line), but quite expensive above $91 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Philip Morris's fair value at this point in time to be about $76 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Philip Morris's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $89 per share in Year 3 represents our existing fair value per share of $76 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
Philip Morris is a favorite of many income-oriented investors, and for good reason. The company has one of the most compelling dividends available and is poised for continued dividend growth. We assign the firm a good dividend safety rating on the basis of its reliable business, but its dividend metrics could be better. We are cognizant of the regulatory risk the tobacco giant may face, including a push for increasing the smoking age to 21 like we've seen in California, but we don't question the company's product pricing strength, which was on full display in 2015. Foreign exchange rates will continue to be a headwind to reported results in the near term. Though we love Philip Morris' exposure to high-growth regions and pricing power, we'd like to see shares trading at a discount to our fair value estimate before considering initiating a position in the firm in the newsletter portfolios.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.