Philip Morris: Too Expensive For Tobacco

Summary

• Philip Morris' powerful position in the growing reduced-risk products market caught my eye while looking for a tobacco dividend stock.
• Acquisitions like the recent Swedish Match deal support Philip Morris’ growth story but high debt at an increasing cost of capital will make it nearly impossible to keep it.
• Upon closer examination, I lost interest because of its high valuation and better alternative investments available.

Diy13/iStock via Getty Images

Investment thesis

Philip Morris International (NYSE:PM) is a highly profitable tobacco stock, which is the pioneer of the reduced-risk products market. Supposedly, the killer of traditional cigarettes. During the first nine months in 2022 RRPs (reduced-risk products) already contributed over 29.8% of total revenue. However, the current valuation is way higher than its peer group and the negative equity combined with high leverage makes me assume that future acquisitions, which fueled growth, are likely to dwindle. Furthermore, the headwinds the tobacco industry already has to endure are tightening and there are no signs of improvement soon.

Introduction

Philip Morris International went public in 2008 after being spun off by Altria (MO). This allowed Altria to solely focus on its business in the USA, while PM had the challenging task of sustaining its leadership as a global player. The company's main products include cigarettes and smokeless tobacco products. The company owns a lot of well-known popular tobacco brands:

The top five most profitable brands are Marlboro, L&M, Chesterfield, Philip Morris and Parliament. Those flag-ship premium brands are accompanied by a lot of low-price and local alternatives. In the first nine months of 2022, PMI's traditional combustible products generated $16.43 billion (-0.9% YoY) of revenue. The 2015 launched reduced-risk products contributed $6.98 billion (+3.7% YoY) to a total revenue of $23.41 billion (+0.5% YoY) (excluding $199 million revenue of the Wellness & Healthcare business).

RRP/THP

Tobacco companies have been facing headwinds as first world countries like New Zealand plan to completely ban selling cigarettes to anyone born after 01.01.2009. However, this does not include the RRPs, which do not burn, but only heat the tobacco to release the nicotine. Those products, such as e-cigarettes and heat-not-burn devices, are considered to be less harmful alternatives than traditional combustible cigarettes. This is because they produce fewer toxic chemicals while delivering nicotine in a less harmful way. However, as I wrote, it is only "less harmful". I want to stress that these products are still harmful for you and the people that breathe in second-hand emissions. According to the CDC the most of a cigarette's toxic emissions still take place in an IQOS, but the concentration is lower. Some reports also suggest that non-combustible products can help to quit smoking by supplying nicotine in a more controlled manner, but the CDC does not support those premature claims due to unfinished research.

While PMI still has the biggest market share at 71.5% (2021) BAT (BTI) is catching up at a high pace and is currently at second place with a market share of 15.3% globally. Since the launch of RRPs in 2016 this branch has been able to report a CAGR in revenue of 51.1% (assuming a revenue of $8.73 billion for 2022 FY). British American Tobacco is catching up by mimicking PMI's successful IQOS and selling a similar product under the brand name "glo". Launched in 2020 the THP (tobacco heated products = similar to RRP) combined with oral and vapor products under the name "Total Non-Combustibles already contributed 14.6% (30.7% YoY growth) to the total revenue of during the first half of 2022. I like BTI's strategy in particular, as it offers its proprietary heater for less than half the price of IQOS. While it is obviously bad for margins at first, it is only a one-time expense for a likely long-term value by supplying the "Glo Neo Sticks". This helps BAT to catch up to PMI's market share. Still, PM has the important first-mover advantage and a five-year lead on its most important competitor, but at current levels the market values PMI as if it will be the sole player in the RRP/THP market.

Fundamentals

With a stable operating income margin of over 40% PMI is highly profitable. The company invests its money very profitable and therefore has a high return on capital employed:

Table made by author using data from Philip Morris International IR

The average ROCE over the last five years was almost at 50%, which means PM is able to generate 50 cents per $1 capital employed. This high value results from PMI's low assets, which include materially less intangible assets and goodwill than its peers. Altria has intangible assets worth $17.48 billion (44% of Total Assets) on its balance sheet, while BAT seems to be at severe risk of future impairment losses at £115.63 billion (84% of Total Assets). In an already planned analysis of BAT, I will further inspect the risk of this balance sheet. Back on topic, using the 2021 EBIT of $12.03 MO's ROCE is 38.9%, which is also at a respectable value. For BAT, however, the ROCE is only at 18.0%.

Cash flows are typically high for all tobacco companies. Since 2015 PM grew its operating income from $7.865 billion to $12.150 billion (assumed for FY 2022), which results in a CAGR of 7.2%. During the same period of time total cigarette shipments decreased from 847.3 billion units to 624.9 billion.

Table made by author using data from Philip Morris International IR

Diagram made by author using data from Philip Morris International IR

Being able to increase profits with a core business shrinking at such a pace is remarkable. The pricing power those addicting tobacco companies have is what allows them to keep paying and increasing their dividends.

Valuation

A good indicator for an overvaluation is the average PE-ratio. Of course, this is only an indicator and is not always reliable.

Data by YCharts

At a current non-GAAP PE-ratio of 18.45 PM seems neither cheap nor expensive, but compared to peers like BTI and MO valued at 8.71 and 9.78, PMI's valuation does not look like a tobacco company but is rather close to a consumer staple company. Apparently, investors expect the future growth prospects and income much safer for PM. Recalling the above stated low quality balance sheet (i.e. negative equity) and questionable amount of debt, I highly doubt that this valuation is justified. To further strengthen my point, I conducted a DCF analysis. I projected the growth for each branch separately and used a rather optimistic outlook for growth in the RRP branches.

In order to calculate the WACC I used PM's cost of debt of 2.4%, which is still quite low because of its well-structured long-term financing. I expect it to go up to around 3.0% depending on the FED's upcoming outlook. The cost of equity is 8.35%. Due to the negative equity of PM, I used the market value of equity. At a current EBIT margin of slightly above 41% PM has already optimized profitability. However, with further market share gain of non-combustible products should have a positive effect on margins: I assume it to go up to 43% over the next ten years. I estimated the terminal growth rate at 1.75% because of major macro headwinds over the long-term future. Putting all these tailwinds in calculation, I still conclude an overvaluation of exactly 27.00%.

Table made by author using data from SA and Philip Morris IR

PM_DCF.xlsx

I attached the detailed file of my complete DCF. Constructive criticism and other comments are welcome, and I will try to answer every question about my growth assumptions.

Dividend

Table made by author using data from SA

At an average payout ratio of ~81%, dividend growth and sustainability seems to be at its limit. Future focus on deleveraging and meanwhile high interest payments should and will be Philip Morris' main focus. At a current yield of 4.90% the dividend is respectable but way below its peers. Meanwhile, BAT has a 7.17% at a current payout ratio of only 65.9%.

Swedish Match Acquisition

Philip Morris acquired Swedish Match in an all-cash offer. PM has paid 106 SEK per share, which values the company at $16 bn. The deal got funded by a combination of debt market and bank financing. It seems quite fair, valuing this already smoke-free tobacco business at 17x 2023 EBITDA multiple. Especially, when considering the high CAGR of revenue of ~17%. By generating over 64% of its revenue in the US, it allows PM to get a foot in the door in this important market. Together with its recent purchase of Altria's permission to sell IQOS in the United States, it will generate positive synergies. I like this purchase and think that these strategic acquisitions put PM in a great spot to keep its market leading position. However, it is important to keep in mind that this costly acquisition will cause the debt to spike. PM has already announced that it will stop its share repurchase program and focus on sustaining its dividend and deleveraging as fast as possible.

Conclusion

I rate Philip Morris International as a HOLD. Strategic acquisitions, a market leading position in smoke-free nicotine, and positive future outlooks seem attractive, but at this current level I do not think PM is well poised to grow into its high expectations. Furthermore, its negative equity and high leverage might cause problems in a long(er) term high interest environment. With over $5.6 billion debt maturing in 2023 and 2024 refinancing is definitely necessary and PM might be forced to do this at a high price. I will keep the company on my watchlist, but am not tempted to buy at the current valuation.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.