- With a risk of a recession hanging over markets, investors may want to consider quality defensive stocks such as Philip Morris.
- PM has a dominant market position in the tobacco industry as well as a track record of profitable operations and consistent dividend growth, with a current yield of 5%+.
- The company is in the midst of a major transition from having cigarettes as its core business to having smoke-free products as its core business.
- This shift could bode well for profitability and growth given the emerging class of consumers adopting smoke-free nicotine use and the higher margin per user for these products.
- At present valuations, the downside risk is limited while the potential for a move higher is significant given the presence of near-term catalysts such as a recession and the imminent entry of PM's smoke-free brands into the US.
Philip Morris International (NYSE:PM) is a tobacco industry stalwart that raked in annual revenues of $31.76 billion in FY2022. This makes it the second largest tobacco multinational by annual sales after British American Tobacco (BTI), which pulled in revenues of $33.43 billion last year. Altria (MO), which is the third largest by comparison, posted revenues of $20.68 billion. With approximately 79,800 employees - a significantly higher number than BTI and MO - PM sells its products in over 180 countries outside the US and is known for leading brands such as Marlboro.
With the risk of a recession presently hanging over the markets, investors may need to get more defensive in their portfolios by increasing exposure to consumer staple stocks. PM is a compelling pick to consider adding to your defensive watchlist or portfolio given its dominant market position in the lucrative tobacco industry. Like any consumer staple stock worth its salt, it has a long history of profitable operations and pays an attractive dividend that has increased for 14 consecutive years.
Moreover, the company is in the midst of a major business transformation that shows great promise going by the progress reported so far. PM is transitioning from having combustible products (aka cigarettes) as its core business to having to having smoke-free products (these include heat-not-burn, vapor, and oral nicotine pouches ) as its core business.
As per its investor presentation, the goal is to have net revenues derived from its smoke-free products accounting for more than 50% of total revenues by 2025. It had reached 32.1% or $10.2 billion in 2022 through organic growth and acquisitions. This is close to double the $5.7 billion achieved just three years ago in 2019, as per its investor presentation.
The company groups its diverse line of smoke-free products under the IQOS brand, which includes heated tobacco and e-vapor products. The rationale behind nicotine users opting for smoke free products is that, since there is no burning, the levels of harmful chemicals are significantly reduced compared to cigarette smoke.
The commercial prospects of PM's ongoing transition to smoke-free products are promising as the smoke-free products are higher margin per user than cigarettes. Moreover, the IQOS brand positioning is premium, meaning PM can charge more.
When it comes to IQOS, there is an opportunity to not only expand margins, but also drive volumes. IQOS users are growing rapidly, given more nicotine users are trying to reduce the harm associated with smoking cigarettes. PM's Q1 earnings presentation showed that its IQOS users increased from 22.7 million in Q1 2021 to 25.8 million in Q1 2023.
The fact that this user base, which pales in comparison to the number of cigarette users, delivered more than a third of total 2022 annual sales underlines the strong commercial prospects of the smoke-free category.
With plans to launch IQOS in the US in Q2 2024 (bolstered by the takeover of leading oral nicotine company Swedish Match), investors can expect continued robust IQOS growth for the next couple of years. This is undoubtedly bullish as far as top line growth goes and will likely be accretive to overall margins given the premium nature of the IQOS brand. Speaking on the US expansion in the Q1 2023 earnings call, Emmanuel Babeau, PM's CFO noted: "With the benefit of the expertise and commercial tools from launching IQOS successfully in over 70 international markets, and a U.S. market with a clear regulatory framework and the ability to communicate with adult smokers, we remain very positive about the opportunity."
If you compare PM's recent capital expenditures with MO and BTI, it is evident that PM is the one investing the most in evolving its product portfolio to capture the current shift towards smokeless nicotine products.
PM's capital expenditures for the trailing twelve months of $1.13 billion is close to double BTI's and five times MO's. This kind of spending should translate into a defensible moat as far as growing and protecting its market share in the smoke-free category is concerned.
Attractive and sustainable dividend
In addition to the potential for relatively strong revenue growth driven by the smoke-free category, PM has an attractive and sustainable dividend. This further strengthens the bull case. The current annual payout of $5.08 works out to a yield of 5.31%, which is attractive even with the increase in treasury yields in the past year.
PM's dividend is sustainable given the fact that EPS is currently at historical highs against the backdrop of a general decline in net interest expenses in recent years. The company's cost of debt for the past five years (2022 - 2018) is significantly lower than the preceding five year period (2017 - 2012).
Limited downside risk with near-term catalysts
PM is not exactly in bargain territory at the current share price, given its P/E (fwd) of 15.56x is close to its 5 year average of 16.13x. Over the past ten years, the only time PM's P/E was above 20x was in the 2016 -2017 timeframe when PM's market cap peaked at around $186 billion in May 2017 (vs the current $148 billion). There were very brief moments over the last decade when the P/E slipped below 15x, suggesting limited downside risk given projections for continued topline and bottom line growth. EPS is expected to reach a record $6.26 in 2023, as per analysts' estimates.
Importantly, PM could benefit from a couple of near-term catalysts, setting the stage for a possible rally from current levels. One of these catalysts is a market rotation to defensive cyclical stocks in the coming quarters in the event of a recession. The second catalyst is the company's 2024 launch of its smoke-free products in the US, which is a key market that PM has historically not played in. Buying PM at the current share price therefore presents an opportunity to lock in potential capital gains while securing a 5% plus yield.
This article was written by
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