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Philip Morris (NYSE:PM) is in a precarious situation due to the natural decline in the tobacco industry and their increasing reliance on vaping and e-cigarettes, which have significantly higher costs (lower margins).
The upside for the company is that they’re using their cash and other equity to pay down and refinance their long-term debt, which in a rising rate environment will aid them to preserve cash down the line for further diversification and restructuring efforts.
On the negative side, however, the declining natural sales of the cigarette market, which is expected to accelerate in the coming years, as well as the lower margins they have in their newly diversified business segments – means that they may ultimately be valued less even if they successfully navigate the world of the tobacco industry.
Let’s take a dive.
The Positives: Lowering Debt Levels
After the company held a record $31.3 billion in long term debt in 2017, they have been slowly paying it down to their recent report of holding $22.3 billion. This, in turn, has led to their interest expense payments to be lowered as well, preserving cash for both present and future diversification and restructuring efforts.
| 2017 | 2018 | 2019 | 2020 | 2021 | Current | |
| LT Debt | $31.3B | $26.9B | $26.6B | $28.1B | $24.8B | $22.3B |
The company has used cash to preserve cash, as interest expense has trended higher for years before decreasing in recent quarters due to debt repayment. This is especially important because the federal reserve has been raising interest rates to combat inflation, which rose to dramatic levels due to the COVID-19 pandemic and global geopolitical tensions, and that means that the company’s floating rate debt will see higher and higher interest expense.
Even though the company has been lowering their long term debt levels, their interest expense is still hurting their business – while the company saw a reduction of 18.6% in debt in their most recent quarter relative to last year, their interest expense only decreased by 9%.
Given that the federal reserve projects that these higher interest rates will persist through 2024, it’s positive that the company is working to lower their long term debt to minimize the cash payments they’ll need to make.
The Negatives: Industry In Decline
Over the next 5 years, the overall global tobacco market is projected to grow at a CAGR (compound annual growth rate) of just 1.8%, which includes much higher growth rate business segments like electronic cigarette and other vaping products. One optimistic point for the company is that women across the United States and the European Union countries are showing higher number of smoking adoption – which should help with the industry’s continuous year-over-year declines.
The problem with the growth in this market, for the long run anyways, comes in 2 parts:
Organic Cigarettes: Margin Contraction
In the organic cigarette market, price increases and some raw material price declines have helped companies in the tobacco industry boost profit margins and hold off some of the major declines the industry has been seeing.
But this has its limits. With inflation already pumping up prices in other industries, there is, I believe, a limit to how much the price of cigarettes can rise to compensate for the loss in overall organic cigarette smokers.
The COVID-19 pandemic supply chain issues also made raw materials and the costs associated with bringing organic tobacco cigarettes to market more expensive. This will be a double whammy for the company’s organic cigarette market and royalties in the longer run.
Even though the organic cigarette market is projected to remain flat, from a growth perspective, over the next 7 years – I expect these headwinds to negatively impact this segment and that the company will face tougher comparative revenue growth rates moving forward.
Next Gen Products: Lower Overall Margins
Even though the growth of vapes and other electronic cigarette remains impressive, the profit margin on these products is significantly lower than those of organic cigarette products.
This is most evident by recent financial reporting by the company – while the company’s revenues increased by 3.1% in their most recent reporting quarterly report compared to the same period last year, their gross profits actually decreased by 0.7%.
For this reason, I project that the company will report a few years of slightly higher revenues on the backs of increased adoption of electronic cigarettes and other vaping and alternative tobacco products but the shift of revenue mix over to lower-margin products will result in their profits to lag well behind.
Balancing The Pros and Cons
While a few years of some modest revenue and EPS growth may be good, the point of my investments is to see how we can maximize returns in a diversified way. While the company can grow its top and bottom lines for a few years, potentially, they also face significant risks with political issues.
While the company can produce a few good quarters, and is likely to keep paying down its debt and run a somewhat sustainable dividend payouts – the overall growth is set, I believe, to underperform the broader market.
There are a few other negatives worth noting:
The company’s dividend is, for now, sustainable. They currently pay out about 87% of their earnings as dividend, meaning that any dips in revenues and subsequent EPS declines may result in an adverse reaction in the company’s share price.
This is due to the fact that many investors, who may not be bullish on the company’s overall long-term performance, are interested in the company due to their current ~6% dividend yield. Even if the company’s share price doesn’t make much gains over the next 10 years – they’ll likely perform similarly to the broader market due to their dividend alone. Therefore, any reduction in the company’s dividend may result in an outsized downwards move to the company’s share price.
The company’s revenue expectations call for an averaged 3.2% growth annually over the next 5 years – which is higher than the overall market. With various other competitive pressures, I don’t believe that the company has any particular advantage, so the likelihood of them gaining market share is low.
This means that what I believe will happen is that analysts will gradually lower these expectations, or if not – the company will consistently miss expectations. This means that the company’s share price, which has thus far outperformed the broader market in the most recent decline – is under more pressure to perform as or above expectations to justify the current multiples.
Conclusion
If all you care about is the company’s high-ish dividend rate and/or believe that the tobacco industry will, for some reason, surge beyond current 1.8% growth rate expectations – an investment may be worth it at current levels.
But as I see it – both of those are unlikely to happen. I expect that while the company’s revenues CAN grow at the currently expected 3.2% rate over the next 5 years – it’s unlikely. Combined with the share price sensitivity related to their high dividend yield, as well as margins being under pressure – the company is highly likely to underperform the broader market.
As a result, I don’t believe Philip Morris constitutes a good long-term investment and I remain neutral to slightly bearish on their 2-3 year prospects.
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