Vertigo3d
The tobacco industry is an age-old one and hasn’t had to innovate for many decades, to the benefit of incumbents, who have consolidated to just a handful of companies over many years. However, disruptive innovation by global leader Philip Morris International (NYSE:PM) has spurred new products that seek to reduce risks for existing smokers. This article highlights why PM is the quality play in the sector, and remains attractively priced considering its moat-worthy attributes.
Why PM?
Philip Morris International is a leading global tobacco company. The conglomerate has expanded its business to include smokeless products, e-cigarettes, and heated tobacco systems, generating $32 billion in total revenue over the trailing 12 months. It has over 40 manufacturing facilities globally that produce market-leading brands, including the well-known Marlboro cigarette brand. It also leads its closest international peer, British American Tobacco (BTI) in R&D spend on next generation products, including the market-leading heated tobacco brand, IQOS.
PM has made a number of splashy headlines in recent months, including its recently accepted bid for Swedish Match (OTCPK:SWMAF), which holds the leading oral nicotine brand, Zyn. This gives PM a road back to the coveted U.S. market since it was split from its parent company, Altria (MO).
As many analysts expected, this newly found distribution arm in the U.S. also compelled PM to break its IQOS distribution agreement with Altria, after paying a $2.7 billion settlement fee to its former parent. Under the terms of the agreement, and due to the import ban stemming from the lawsuit from British American Tobacco the earliest PM would be able to manufacture and sell IQOS in the U.S. is 2024.
Nonetheless, this represents a compelling opportunity for PM, as any revenues and profits that it gains in the U.S. would be incremental to its existing run-rate, as PM currently has no presence in the U.S. One potential headwind, however, is that PM would be unable market its IQOS heat sticks under the valuable Marlboro brand, as that belongs to Altria, which now has an agreement to market Marlboro branded heat sticks with Ploom X heated tobacco devices as early as 2025.
Meanwhile, PM has bucked the trend of declining volumes, with heated tobacco helping to stem the decline. This is reflected by sturdy volumes during the third quarter, with total tobacco volume up 0.6%. This is even more impressive considering that it cycled volume growth last year, when more people were socially isolated during COVID and smoking more. Also encouraging, the combined volume growth for PM’s total tobacco category implies that it achieved net customer growth, though it will take more quarters to see if it is a sustainable trend.
Notably, the fact that PM currently derives all of its earnings overseas means that it’s subject to currency headwinds, considering that the dollar has strengthened over the past year, thereby making its overseas earnings less valuable. However, the strong dollar has had the effect of strengthening its debt metrics on PM’s A- rated balance sheet, as noted by management during the recent conference call:
I would also like to highlight that U.S. dollar strength has a positive impact on our net debt, given that more than 60% of our financing is in euros, including derivative overlays. This serves to offset the impact on our earnings and, combined with strong cash generation, contributed to a $1.5 billion reduction in our net debt since December 2021, which is now below 1.6 times adjusted EBITDA on a 12-month rolling basis.
This delivery highlights our ability to maintain a strong balance sheet, pay down debt, and invest in the growth of our business. In addition, we recently increased our annualized dividend for the 15th consecutive year, in line with our long-term commitment to return cash to shareholders.
Lastly, PM pays an attractive 5.2% dividend yield that’s covered by an 85% payout ratio. While the stock is not cheap at $96.90, it does come with a forward PE of 17.2, which sits below the traditional 18 – 20x range for most consumer staples companies. PM’s current valuation also doesn’t consider the fact that PM’s products enjoy more price inelasticity than most other consumer staples and the incremental earnings potential from a re-entry to the U.S.
Investor Takeaway
PM at the current valuation presents a good opportunity for investors looking for exposure to the durable nicotine market, as PM’s IQOS heated tobacco products are gaining traction globally and the company will hold the number one oral nicotine brand in Zyn.
While investors will need to be patient on the IQOS reintroduction to the U.S., I believe it will ultimately prove to be rewarding. As such, I view PM and its above 5% dividend yield as being a quality and safe choice for dividend growth investors.
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