Sector – Consumer Staples
Investment Style – Large Cap
Price Target - $66
Trade Tip: Short PM’s 3.9% yield 2013 bond and go long on PM stock with a dividend yield of 6.5%. Arbitrage value, assuming non-material trading cost and no change in PM’s dividend, is 2.6 percentage points. I’m not considering the risk of decline in stock price because by buying the stock an investor is assuming that risk already and this is just an option to the simple long on stock strategy. The probability of a dividend cut or a further decline in PM’s bond yield is pretty low.
Valuation: A DCF valuation of PM yields a price of $66, an upside potential of 100% to Friday’s (03/06) closing price of $33.34. The valuation model is sensitive to changes in short-term revenue growth (5%), sustainable net profit margin (11.5%) and long term cost of equity (9.7%). PM’s 2008 revenue growth has been in the 6% range and net profit margin in the 11% range. PM’s revenues are well diversified geographically and it operates in a stable tobacco industry; a cost of equity of 9.7% 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 11X to 18X in the last five years; PM with its estimated EPS of $3 for 2009 could trade in the $33 to $54 range in 2008-2009. At its current quote, the stock is trading at the low end of the historical PE valuation. Moreover, it’s PEG ratio is 0.9 with a PE of 10 and an estimated 11% EPS growth in 2009. Additionally, a 6.5% dividend yield reduces the downside risk of this stock. PM’s P/S ratio is 2.77 while its P/Free CF is at 9.7.
PM’s earnings yield (NI/Market Cap) for 2008 is at 10.3% while it bond yield is at 3.4%. This spread of 7.9% between PM’s earnings yield and bond yield combined with a 6.5% dividend yield more than justifies buying PM stock when compared to its bond. It’s TEV/EBIT for 2008 is at 7.5 while free cash flow (CFO-CFI) was at 10% of its current market cap.
Profitability Analysis: PM’s ROE has increased to 60% in 2008 from 39% in 2007 owing to a slight increase in asset turnover and almost doubling of financial leverage.
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; the production is on schedule and it has started contributing in Q4-2008 (although not material so far) to the top-line. PM’s Asian revenues (excluding China) grew at a CAGR of 6.2% in 2008 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 2008, EMEA has been the fastest growing region (in terms of revenues) at a CAGR of 13.6% while sales in Europe declined in 2008 by 0.8%. Moreover, 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 US factories to PMI factories expected to be about two months ahead of schedule. EPS is expected to grow by 11% in 2009 and 12% in 2010.
Insider Trading: All insiders including the CFO have bought shares in the $50 range without a single insider sell transaction below $42 in the last one year. In May 2008, PM announced a $13 billion two-year share repurchase program; in 2008, PM spent $5.4 billion of the $13 billion on buy backs. The remaining $7.6 billion constitutes 11.3% of its market cap based on PM’s March 06 closing price.
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 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 a particular type of tobacco, it is difficult for other products to gain prominence.
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 36% in 2008. PM’s growth in emerging markets has to offset the decline in EU shipments. A world-wide recession could hurt PM’s sales since it sells premium brands and most of its new customers trade-up from local cigarette brands. However, the current revenue and EPS estimates have considered these declines to quite an extent.
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.
All of PM’s revenues are from international operations and so it has significant currency risk. However, it could be a natural hedge against the dollar for investors with extensive US investments.
Conclusion: PM has limited downside risk in the current oversold market conditions with above average dividend yield and high growth potential owing to its strong brands and low penetration in major emerging market countries such as China, India and Vietnam.
Disclosure: The author and his firm are long on PM