Why Trump Will Be Bad News For Philip Morris

| About: Philip Morris (PM)

Summary

Trump’s economic policies could lead to a stronger dollar and a negative currency effect for Philip Morris.

However, Philip Morris is well-placed to offset this through reduced risk product (RRP) development.

It also has a tailwind from emerging markets, where growth opportunities remain high.

Trump's policies are likely to cause the dollar to strengthen, which will hurt exporters such as Philip Morris (NYSE: PM). Although there is a high degree of uncertainty surrounding exactly how Trump's administration will manage the economy, higher spending and lower taxes could lead to upward pressure on inflation. As a result, the Federal Reserve may become more hawkish and this could mean an even stronger dollar.

Since Philip Morris operates abroad, it could be subjected to a negative currency effect. However, in my view it remains a sound long term buy. I believe that the potential for emerging market growth, development within the reduced risk product (RRP) space and the strength of its brands could mean that it overcomes the challenges posed by a Trump-led government. Therefore, I'm still bullish on its future.

A rising US dollar

The US dollar is already at its strongest level since 2003 when compared against a basket of major currencies from around the world. This is bad news for Philip Morris and in its most recent quarter the company reported a negative currency impact of $0.04 per share. This reduced the company's EPS by 3.2% and in my view this could get worse in the 2017 financial year.

The main reason for this is Trump's spending policies. As mentioned, nothing has been confirmed yet but it seems likely that the new President will follow through with his promise to boost infrastructure spending. Whether this is by as much as the $500 billion which was promised during the election campaign is unclear. However, it is likely to be considerably higher than current levels. When coupled with Trump's policy of reducing taxation on individuals and businesses, this could lead to higher levels of inflation.

The impact of inflation on the Federal Reserve's standpoint is likely to be significant. Although the Federal Reserve has thus far been cautious about raising interest rates, a more hawkish viewpoint is likely to pervade in future if inflation picks up. In other words, in my view higher inflation will give the Federal Reserve one less reason to keep rates low and one more reason to raise them.

Already, the Federal Reserve is expected to raise interest rates six times in the next three years. Higher inflation could increase the number of interest rate rises, which would be likely to strengthen the US dollar. That's especially the case since Japan, the Eurozone and UK are forecast to have looser monetary policies than the US over the same timeframe. Therefore, while Philip Morris's EPS has been hurt by just over 3% by negative currency impacts in the most recent quarter, a higher percentage could be just around the corner.

Offsetting positive catalyst

Despite the potential for negative currency effects in future, I remain bullish on Philip Morris. A key reason for this is the growth potential within reduced risk products (RRPs). In my view, Philip Morris is better placed than the rivals it has outside of the US because it has partnered with US-focused Altria on RRP development. This provides the two companies with greater financial firepower and means that they may be best able to capitalise on the shift in consumer tastes towards less harmful nicotine delivery products.

As such, I believe that e-cigarettes will prove to be the first in a wave of new RRPs which gradually become more successful at mimicking the taste and feel of a cigarette, while also having minimal negative health effects.

Philip Morris has a strong position within the RRP space thanks to the strength of its Marlboro brand. This provides it with the opportunity to launch new RRPs under the Marlboro brand in order to immediately gain a customer base. Evidence of this can be seen in Japan, where Philip Morris launched Marlboro HeatSticks and already has a quarterly share of 3.5%.

As such, Philip Morris has a captive audience under the Marlboro brand, which is the biggest cigarette brand in the world and the 26th biggest global consumer brand. This means that as well as having greater financial firepower thanks to its tie-up with Altria, Philip Morris also has a lower risk route to market via its Marlboro brand. This should reduce the payback period on R&D and allow Philip Morris to take greater risks with its RRP development.

Emerging market growth potential

In addition to the opportunity for RRPs, Philip Morris's exposure to the emerging world also helps to offset the potentially damaging impacts of a stronger US dollar. More than 80% of the world's smokers now live in low and middle-income countries, which is where Philip Morris's business is focused. This figure is likely to increase as the proportion of adults in the developed who smoke continues to fall, while population growth in the developing world means that the absolute number of smokers is likely to rise in future.

In fact, between 2014 and 2019, the global value of cigarette retail sales is expected to increase by 29%. With Philip Morris having the world's biggest cigarette brand, Marlboro, in its stable, it has superior pricing power compared to many of its rivals. As such, I believe that it will be better able to increase prices without hurting volumes to the same extent of its sector peers. This should result in higher profitability over the medium term.

Outlook

In my view, a Trump Presidency will cause Philip Morris's earnings to be hurt to an increasing extent by negative currency effects. His promise to reduce taxes and increase spending could lead to higher inflation. In turn, this could mean higher interest rates and a stronger dollar. Already, the dollar is at its highest level versus a basket of currencies since 2003, which means that it could become increasingly challenging for exporters to record higher reported earnings.

Despite this, I'm bullish on Philip Morris's future outlook. I believe that it has an opportunity to dominate the RRP category thanks in part to its combination with Altria. Further, the strength of its Marlboro brand means that it should have a more captive audience than rivals and deliver a shorter payback period on R&D. Alongside a favourable tobacco market outlook for emerging markets and a rising population, I feel that Philip Morris remains a sound buy for the long term.

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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.

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