Philip Morris International (NYSE:PM) is a world leading international tobacco company. You might remember that PM was spun off by Altria Group (NYSE:MO) back in March 2008, and since then the shares are up by more than 163% including dividends. As such, PM owns the international rights to the Marlboro brand outside the US, among many other top brands. How fitting that PM, the spin off (or child) of the parent company, King MO, is the king of tobacco outside the US. Talk about a parent being proud of their child! Excluding the protectionist Chinese market, and the US market, PM has the highest market share of cigarette and heated tobacco products in the world at about 28%. I will talk about PM's competitive advantages that have brought it success up to this point, as well as innovative steps that PM is taking in order to stay on top.
Philip Morris International's Competitive Advantages
· Brand Recognition: The Marlboro brand is a behemoth for PM as it's the number one leading brand for PM in virtually every market. Although PM does not advertise anymore, the Marlboro brand has a large share of mind even among non-smokers. Call it genius or luck, the marketing of the Marlboro brand worked wonders with smokers so much so, that even without any advertising, the brand continues to dominate.
· Low Capital Expenditures: Earnings mean nothing if the business requires a lot of cash to maintain their operations. Take oil companies as an example, they earn billions of dollars per year only to pour more than half of it back into the business to maintain/improve operations. Those expenditures really reduce the amount of cash a business has to distribute back to shareholders. According to Q1 2017 earnings, PM only spends 12% of their operating cash flow to maintain their operations.
· Lack of Frequent Innovation: I stress the "frequent" part of this point. This may sound counter intuitive but in business, innovation can hurt you just as much as help you, the double edged sword of growth if you will. To see how innovation could kill a business you've invested in, we will employ the $100B dollar test. Simply answer the following question: If someone gave you $100B could you come up with a way to hurt the company, or steal their customers away? Could I build a better cigarette with $100B dollars? Could I build a bigger brand than Marlboro? Probably not. Could I build a better, cooler iPhone? Probably. See the point? PM does not need to worry too much about their core cigarette business changing and possibly ceding a lot of sales to their biggest competitor.
In terms of reduced risk products, PM has made significant progress by developing their IQOS e-cigarette and is having tremendous success selling it worldwide especially in emerging markets. According to Q1 2017 earnings, PM's iQOS heated tobacco sales volume grew from 400M units in Asia in Q1 2016 to over 4B units last quarter! Accordingly, revenue from iQOS grew from $50M in Q1 2016 to $400M in Q1 2017, representing about 7% of PM's revenue. Currently, PM's core cigarette business still drives most of the profits, but I'm optimistic that future growth of iQOS will eventually overtake cigarette sales and profits. In the meantime, profits from PM's core cigarette business will continue to fund expansion of reduced risk product innovation while rewarding shareholders.
· Competent and Shareholder Oriented Management: This final point is somewhat rare to come by. You can have a beautifully run business only to see management squander the profits on useless acquisitions. PM management consistently returns over 90% of free cash flow to shareholders via dividends and buybacks, sometimes borrowing to fund buybacks. PM's dividend has more than doubled since the company was spun off in 9 years ago and the share count has gone down from 2.1B since the spin-off to 1.55B today. In essence, over the past 9 years since the company was spun off, PM's dividend has grown at a compound annual growth rate or CAGR of 8% per year, and the shares outstanding have been reduced at a rate of 3.4% per year.
But How Much is Philip Morris worth Today?
To asses PM's fair value, I will use the discounted earnings per share valuation method and tweak my assumptions until I solve for PM's current price. PM is forecasted to earn $4.9 per share this year and if we assume these earnings will grow by 8.85% per year for the next 8 years, and then achieve terminal growth of 2.0%, we arrive at a fair value estimate of $112.15, the current stock price.
Source: My Excel Calculations
I believe PM to be fairly valued at this point in time, as it seems all the future growth is being priced in and would not recommend adding large quantities of shares to existing positions. A growth rate of 8.85% for the next 8 years is just about pricing for perfection, so prospective may wish to wait for a better entry point. Prospective shareholders would certainly not be punished purchasing PM today, but should be mindful that future returns may suffer should PM not achieve these growth targets.
PM is a solid business with excellent fundamentals, however shares are fairly valued at this point in time. I do think that PM shares could get pulled down in a broader market correction, and I'd look to add or initiate new positions upon a 5%-10% correction in the stock price.