- There have been rumors from time to time that Philip Morris may merge with Altria.
- This is somewhat surprising, as the two companies separated just a decade ago.
- However, the reasons behind the initial spin-off are not valid any more.
There have been rumors from time to time that Philip Morris (NYSE:PM) may merge with Altria (NYSE:MO). Wells Fargo has assigned a 70% probability to the merger while Altria was the most mentioned stock in a Bloomberg M&A survey. The two companies separated a decade ago so it should be somewhat surprising, at least on the surface, to hear rumors that the two tobacco giants will reverse their strategy. Nevertheless, as the business conditions have changed in the tobacco industry during the last decade, in this article I will analyze whether Philip Morris is likely to recombine with Altria.
First of all, the main objective behind the split of the two companies was the diversification of the litigation risk. More precisely, the spin-off of the international company made it harder and less profitable to sue the company. Nevertheless, while the litigation risk was elevated a decade ago, it seems to have decreased nowadays.
The other objective behind the initial split of the companies was to enhance shareholder value. The domestic company, Altria, was growing slowly whereas the international segment, Philip Morris, was viewed as a high-growth stock. Therefore, the release of the high-growth segment was supposed to lead the market to fully appreciate it and thus expand its P/E ratio. While the plan was reasonable, things turned out quite differently. More precisely, during the last decade, Altria has essentially doubled its earnings per share whereas Philip Morris has grown them by just 15%. Consequently, Altria has pronouncedly outperformed Philip Morris during the last decade (182% vs. 111%, excluding dividends). In addition, Philip Morris is now trading at a trailing P/E=22.8 so there is not much room for further P/E expansion. Therefore, this factor, which was critical in the split of the two companies, does not seem to have merit any more.
It is also worth noting that the tobacco industry is going through a major transformation thanks to the propagation of IQOS. This product of Philip Morris has been launched with great success in 31 markets so far. In Japan, the only country in which a national roll-out has taken place, the product has gained a 13.3% market share. While the reduced-risk tobacco products have exciting growth potential, they also have high R&D costs. Therefore, it would make sense for Philip Morris and Altria to recombine in order to share the R&D expenses and improve their efficiency. In addition, it is much more efficient to have a single company operating the process for the regulatory approval of IQOS as reduced-risk products. FDA has not accepted this characterization so far and requires solid evidence to approve of this status. Consequently, the regulatory process is likely to be lengthy.
It is also remarkable that a merger between the two companies would mitigate the currency risk of Philip Morris. Since 2014, the dollar has pronouncedly strengthened. As a result, Philip Morris, which generates all its revenues abroad, has incurred a strong currency headwind in its earnings. Fortunately for the company, the dollar has weakened during the last year. Nevertheless, the company always runs the risk of being hurt by a strong dollar. Moreover, while the dollar may depreciate vs. some strong currencies from time to time, such as the euro and the Swiss franc, it almost always appreciates vs. the currencies of countries with weak economies, such as those of Africa and Venezuela. Even worse, there is absolutely no way to hedge against the devaluation of these weak currencies. Therefore, if Philip Morris acquires Altria, it will drastically mitigate its currency exposure, as it will be generating about 40% of its sales from the domestic market. Moreover, it will not need to repatriate any cash; instead it will be able to use the excessive free cash flows of Altria to fund its generous dividends and share repurchases.
While all the above factors indicate that there are good reasons for a recombination of the two tobacco stalwarts, the two managements may find it difficult to proceed with a merger. More precisely, as the two companies split only ten years ago, the managements will certainly face some criticism from the investing community if they offset the strategic decision they made back then. Many investors will also remember the words of the legendary investor Peter Lynch, who has stated that managements proceed with spin-offs and mergers, not to enhance shareholder value, but only to please their shareholders in the short term. As the market usually gets enthusiastic about such M&A moves, the shareholders get excited by the short-term returns of their stocks and hardly ever evaluate the strategic decisions with a long-term perspective. Nevertheless, although a possible recombination of the two tobacco giants will inevitably raise criticism, the two managements can claim that the business conditions have significantly changed since the companies separated. Therefore, they can reasonably justify a merger.
To conclude, there have been rumors from time to time that Philip Morris may acquire Altria. Although the two companies separated just a decade ago, the underlying business conditions have changed and hence a merger is possible. The litigation risk has attenuated while Philip Morris is not growing faster than Altria any more. Moreover, it will be much more efficient for the two companies to merge. In this way, they will share the high R&D costs of reduced-risk products and will operate the regulatory processes much more efficiently. All in all, it makes sense for the two companies to merge.
This article was written by
Analyst’s Disclosure: I am/we are long PM, MO. 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.
I am long PM, MO via short positions in put options.
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