Why I'm Bullish On Philip Morris Despite This Risk

| About: Philip Morris (PM)
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Summary

A stronger dollar could cause a further negative currency impact on Philip Morris’ earnings.

Its exposure to the emerging world and the strength of the Marlboro brand should positively catalyse its earnings.

Reduced Risk Products (RRPs) provide Philip Morris with significant mid- to long-term growth potential.

As a company which operates almost exclusively outside of the US, exchange rates matter to Philip Morris (NYSE:PM). Nearly all its earnings are derived in currencies other than the greenback. The potential for a rising US interest rate and stronger US dollar could therefore cause negative currency effects on the company's financial performance. However, in my view, this risk is offset by the growth opportunities which Philip Morris has in the developing world and in its reduced risk products ("RRPs").

Interest rates

There has been much discussion concerning when US interest rates will rise. A recent poll showed that economists believe there is a 70% chance of a rise in rates in December. This could cause the dollar to strengthen in the near term, which would be bad news for Philip Morris. Already, Philip Morris has been hurt by a stronger dollar. For example, in its Q3 update the company experienced a negative impact of currency of $0.04 per share. This reduced Philip Morris' EPS to $1.25 and a higher interest rate could cause a continuation of this trend.

However, in my view the risk to Philip Morris from a stronger dollar is modest. The Federal Reserve is forecast to raise rates only once in the next year. Further, rates are forecast to be 2.25% in 2020. This shows that the Federal Reserve is likely to be cautious regarding the tightening of monetary policy. They are unlikely to quickly adopt a hawkish viewpoint. This means that currency translation may be negative for Philip Morris over the medium term, but not significantly so.

International growth

While Philip Morris' exposure to non-US markets leaves it exposed to some negative currency effects, it also provides the company with growth opportunities. Across the developed world, smoking is becoming less popular. In the US, for example, the proportion of adults who smoke fell from 21% in 2005 to 17% in 2014. This trend is likely to continue as tighter regulations across the developed world and a more health conscious consumer cause volumes to decline.

However, Philip Morris has significant exposure to the emerging world. In fact, in the ten years to 2014 cigarette sales in Asia, the Middle East and Africa have increased while all other regions experienced volume declines. Further growth is expected in countries such as India, where manufactured cigarettes accounted for only 5% of the market in 2014.

Part of the reason for this is an expected rise in world population. It is forecast to increase by 33% to 9.7 billion between now and 2050. Growth is expected to be centered on Africa and Asia, which could provide a demographic tailwind for Philip Morris over the long run. Fewer regulations across the emerging world also provide more scope for marketing than in developed countries. Less regulation could also mean that the proportion of smokers across the emerging world stays higher than it otherwise would be if public smoking bans, plain packaging laws and other regulations were put in place.

Product strength

Philip Morris has a major advantage over other international tobacco stocks in my view. It owns the international Marlboro brand, which is the most popular cigarette brand in the world. In fact, Marlboro was the 10 th most valuable brand in the world in 2015 according to consultancy Millward Brown. Its value had risen by 19% in the previous year and it has been in the top 10 most valuable brands in the world for a decade.

Marlboro's dominance provides Philip Morris with greater pricing power than many of its sector peers. Cigarettes have a price elasticity of demand of around -0.5, but in Marlboro's case this may be even lower since customer loyalty towards the brand is higher than for other brands. Therefore, Philip Morris should be able to raise prices across its markets at a faster pace than rivals.

Further, Philip Morris has significant growth potential within the RRP space. RRPs are forecast to record annualised growth of 24% over the next 4 years. Philip Morris is due to ramp-up production of its iQOS RRP in Q1 2017. So far, it has delivered a strong performance across all of its geographies. Notably in Japan, where HeatSticks recorded a quarterly share of 3.5% in Q3. With Philip Morris and Altria (NYSE:MO) working together on developing new RRPs, I think that they have a competitive advantage over sector peers. They have more capital to invest and can afford to be more ambitious with their development programme due to the utilisation of their combined financial strength.

Outlook

Rising interest rates are a cause for concern for investors in Philip Morris. They are likely to cause a stronger dollar and a negative currency translation on Philip Morris' EPS numbers. However, in my view the impact will be modest since forecasts for the next four years show that the Federal Reserve is likely to remain relatively dovish.

Further, Philip Morris' exposure to international markets provides significant growth potential thanks to population growth forecasts and fewer regulations. Its development of RRPs should also gain an advantage from the deal with Altria, as well as the double-digit growth forecasts for the sector over the next four years. Its Marlboro brand strength also provides substantial pricing power. Therefore, I feel that Philip Morris offers significant upside moving forward.

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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.