US Equity Research: September 2008

-->Valuation: JFCG's valuation of PM yields a price of $74, an upside potential of 48% to today’s (09/22) closing price of $50. The valuation model is sensitive to changes in short-term revenue growth (10.1%), sustainable net profit margin (11.4%) and sustainable cost of equity (9.3%). PM’s y-o-y revenue growth for the last two quarters has been in the 14% range and net profit margin has been in the 11-12% range. PM’s revenues are well diversified geographically and it operates in a stable tobacco industry; a cost of equity of 9.3% is quite conservative for such stable firms. PM doesn’t have a long enough trading history but its former parent MO has been trading in the PE range of 13X to 18X in the last five years; PM with its average estimated EPS of $3.75 for 2009 could trade in the $49 to $68 range in 2008-2009.

Scenario & Sensitivity Analysis: A scenario analysis shows that PM’s current stock price reflects low short term revenue growth at 2% or a low sustainable net profit margin of 7%; either one of which has a low probability. PM’s intrinsic value is more sensitive to net profit margins; each percentage point in net margins is equivalent to $5.5/share of intrinsic value. Net profit margins at PM have been very stable and is unlikely to change anytime soon.

Tobacco Sector Analysis: Extensive regulation, taxes and litigations risks have hampered the growth of this industry in much of the developed world. Litigation risk is high in US but almost non-existent in emerging markets. PM is not liable for any litigation in the US since Altria owns all of PM’s brands in US. All these issues have also led to consolidation in the industry in the last few years and increased barriers to entry. Tobacco industry has a HHI of 3100 and the top ten brands from the big four tobacco companies make up about 80% of the market; PM owns seven out of the top 15 brands in the world. The high cost of litigation, lobbying various governments and creating a brand benefits companies with scale in this industry. It is almost impossible to quickly penetrate this market with a new brand and so competition in this industry is more likely to come from existing players acquiring local brands.

Tobacco producers are scattered around the world and hence don’t have a lot of bargaining power while negotiating prices for their produce. On the other hand, consumers can easily switch to cheaper brands if the economic conditions warrant such a change and so brand recognition is the key to retaining consumers. A variety of products compete for the consumer’s tobacco dollars, however, once a consumer is addicted to cigarettes, it is difficult for other products to gain prominence.

Growth Catalysts: PM achieved impressive international growth as a part of Altria and was spun-off in April 2008 with rights to market PM brands in all countries but the US. PM can achieve much better results with its focus on international markets without the baggage of US litigation risk and regulation.

In Dec 2007, PM formed a joint venture with China National Tobacco to manufacture PM branded cigarettes in China and are expected to hit the markets in Q3-2008. PM’s Asian revenues (excluding China) grew at a CAGR of 9% in the past three years and the introduction of PM brands in China could push this growth rate into double digits in 2009-2010. Similarly, India is another growing market for cigarettes and PM is in talks to manufacture Marlboro locally. Chinese and Indian growth has not been factored in the valuation model so far since it is not expected to be materially significant in the next few quarters. In the last three years, EMEA has been the fastest growing region with a CAGR of 11%.

All insiders including the CFO have bought shares in the $50 range without a single insider sell transaction below $52 in the last six months. In May 2008, PM announced a $13 billion two-year share repurchase program; as of Q2-2008, it has spent $2.1 billion out of the $13 billion approved by the Board of Directors. PM’s three year $1.5 billion productivity and cost savings program is on track with the first big element of resourcing of volume from USA factories to PMI factories expected to be about two months ahead of schedule.

Risk Factors: PM’s European volume shipments have been on a decline in the past one year and Europe is the largest revenue generator for PM with a revenue share of 49% in 2007. In the past three years, PM was able to offset lower volume shipments in EU by increasing prices and the overall revenues grew at a CAGR of 3.8%. Overall, PM’s growth in emerging markets has to make up for the decline in EU shipments.

An increase in inflation world-wide could hurt PM’s sales since it sells premium brands and most of its new customers trade-up from local cigarette brands. However, in case of PM, inflation is a double edged sword: it could mean weak sales for PM in certain regions but the underlying reason for world-wide inflation is that more consumers have resources to buy goods, which increases the international customer base for PM products.

Litigation costs and increasing regulation in developed countries is a major concern for tobacco companies. PM doesn’t generate revenues from US and is unlikely to be liable for any litigation in US; it is also immune to any future US regulation. Anti-tobacco laws in other regions of the world are not strict enough to cause any material impact on PM’s bottom-line. The recent acquisition of Rothmans in Canada is the only major source of litigation risk for PM.

Overall, PM has limited downside risk in current volatile market conditions with above average growth potential owing to its strong brands and low penetration in major emerging market countries such as China, India and Vietnam.