I'll tell you why I like the cigarette business.
It cost a penny to make. Sell it for a dollar.
It's addictive. And there's a fantastic brand loyalty.
Say what you will about smoking. We at The Hedge Zone don't personally partake. But what we do partake in is profitable investing. And, in our judgment, there is not a better place to put your money today than Philip Morris International (PM).
Let's start by taking a look at Philip Morris' five year chart below, courtesy of Yahoo! Finance. For purposes of comparison, we included the S&P 500. Note that the chart reflects price only, without accounting for dividends. Philip Morris offers an annual yield of 3.5%, besting the S&P 500's average yield of approximately 2%:
The performance is stellar. Now consider this: Philip Morris is a purely international play on the cigarette business. When it was spun off from Altria (MO) in 2008, Altria retained the business segments responsible for the manufacturing and sale of cigarettes (as well as other tobacco products and wine) in the United States while Philip Morris International became responsible for the larger and faster growing international business. While U.S. markets over the past year have held up fairly well, international markets - the real barometer for PM - have experienced a significant correction. One might have expected Philip Morris' stock, with purely international exposure, to have felt the effects of the global economic slowdown. In fact, just the opposite occurred. As evidenced by the chart below, courtesy of Yahoo! Finance, comparing Philip Morris' performance to the iShares MSCI EAFE Index ETF (EFA) and the iShares MSCI Emerging Markets Index ETF (EEM), PM more than outperformed; it soared. Again, note dividends are not included:
But this is nonetheless historical performance, and we view Philip Morris as a "forever" stock. Why forever? Warren Buffett encapsulated it in five sentences, but we'll give you the three main reasons we love PM as a long-term holding: brand loyalty, indefinite and massive growth prospects, and an investor-friendly corporate culture. Note that valuation isn't one of the reasons we like Philip Morris. We set our price target for the stock well into triple digits on account of expected future growth, not current value. To be clear, we consider this a growth stock and not a value play. As the brand expands into emerging markets, including the relatively untapped smoking population of China, we see every reason to expect continued and sustained earnings growth that should correspond to favorable shareholder gains.
The Question of Valuation
Trading at 17.87 times current earnings and 14.69 forward earnings, Philip Morris isn't priced grossly high relative to its earnings. It is, however, priced extremely high relative to its book value and carries a significant debt load. But we tend to discount the debt burden given the pricing power Philip Morris' brands wield and the consistency of earnings growth the company has demonstrated. For a more value-oriented investment in the international cigarette market - and one less leveraged - you may consider British American Tobacco (BTI) trading at 7.6 times book value and owning a higher dividend yield. Head-to-head, however, we favor PM for its brand power.
For the domestic cigarette market, which we view as less attractive due to potential legal/regulatory landmines and waning cigarette use, Altria is our favorite pick and a solid defensive play with a beta of 0.39. In fact, we recently profiled Altria as one of several stocks to help weather the coming correction. Brand loyalty is our primary reason for liking Altria, as well as its history of investor-friendly actions, including its spinoff of Kraft (KFT) and Philip Morris International. Despite its merits as a defensive dividend holding (with a projected yield of 5.4%), Altria also has sneaky growth potential - it has quietly been growing its smokeless tobacco and wine businesses and maintains a voting interest in SABMiller. Of note, last week Wells Fargo upgraded Altria from Market Perform to Market Outperform, citing growing profitability.
Still, priced at almost 17 times book value and carrying a large debt load, Altria isn't the most clear-cut value stock. For alternatives, Reynolds American Inc (RAI) might be a truer domestic value play trading at 3.8 times book value, but its profit margin is lower than Altria's. We should note, as well, that at the same time it upgraded Altria, Wells Fargo downgraded Reynolds American to Market Perform. Lorillard (LO) is another intriguing domestic tobacco choice. More speculative than Altria or Reynolds American, Lorillard is a domestic growth play that naturally offers higher upside but at significantly higher risk.
We set our price target for Philip Morris International at $115.