In the eyes of many investors, Philip Morris (NYSE:PM) had a disappointing quarter. Revenues fell 3.1%, missing analyst estimates by $120 million, and EPS came up short by $0.05. Market share "excluding China and the US" fell 0.4 points, and organic cigarette shipment volumes fell 4.8%, compared to a decline of just 1.4% in the same period last year. However there are many of reasons to be optimistic, and while we would not recommend investing at these levels, PM's long-term growth story remains in tact.
Philip Morris actually had a pretty good quarter when you analyze the results on a currency-neutral basis and take into account the difficult comp from last year. In Q2 2015 sales fell 12.1% due to FX headwinds. On a constant currency basis, sales in the comparable period last year increased 4.5% thanks to favorable product mix as the higher margin Marlboro 2.0 increased share in Asia, Eastern Europe/Middle East/Africa, and Latin America and Canada regions. In the latest quarter, PM's sales increased 1.4% on a constant dollar basis. It is impressive that PM managed to grow revenues over last year even though volumes fell almost 5%, and it is a testament to the firm's pricing power that should continue to drive growth in the long term.
EEMA was responsible for the bulk of the volume declines in the latest quarter as low energy prices weighed on growth in the oil-dependent region. But most of the volume declines in this region came from lower margin brands, and PM actually received a tailwind from a more favorable product mix. PM's most lucrative brands are less income elastic, and therefore less exposed to macroeconomic and geopolitical headwinds. We see this as a sign that PM can continue to grow by leveraging the pricing power of its best brands, even within a sluggish macro environment. Thanks to easing currency pressures, management raised its currency neutral EPS guidance to $4.45 to $4.55 for 2016, which implies constant currency EPS growth of 10-12%. Not bad for a company who reported a "weak quarter".
Emerging markets are in the midst of a slowdown, but the long-term outlook for PM remains positive. Management should be able to raise prices enough to offset declining cigarette volumes as emerging market incomes rise and consumers shift to premium brands. PM's shipment volumes will decline at a slower pace than some of its peers because the company doesn't have exposure to the US where volumes are falling the fastest and where anti-tobacco regulations are the most strict. We also see two catalysts that could drive the stock higher in the short-term. The market still expects the Fed to raise interest rates soon, but we think rates will remain lower for longer as the US economy is too dependent on low rates. This would drive investor demand for yield, and PM would be a big beneficiary. The company is one of the better dividend stocks around, with a stable yield of 4.1% compared to 3.3% for the peer group. And, if interest rates do not go up as high as the market expects, the dollar will depreciate as the primary reason for dollar strength in recent years has been the belief that US interest rates were set to rise. Currency has a big impact on PM's reported results, and a weaker dollar would lead to higher reported revenues for Philip Morris.
Even though PM missed on revenue and earnings, the stock price hardly moved. Given the challenging macro environment and a difficult comp from last year, PM actually did pretty well. The long-term story remains in tact, and if the Fed doesn't lift-off soon (i.e. raise rates more than 25 basis points in the next six months) PM can go higher. However at current valuations investors should be cautious. PM trades at a trailing P/E of 23.5, a 40% premium to its five-year average of 16.8.
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