Philip Morris says cigarette sales in many places could end in a decade and they’ve got a ‘safer’ product to replace them

Philip Morris International Inc. thinks the sale of cigarettes could come to an end in countries around the world in the coming years, but have no fear, because they’ve got another product ready to sell that offers a “safer” nicotine fix.

Philip Morris

and the Food and Drug Administration announced this week that the company’s IQOS “electrically heated tobacco system” has been given the green light to market as a safer alternative to cigarettes.

Now designated as a “modified risk” product, the company can promote these items “as containing a reduced level of or presenting a reduced exposure to a substance,” according to the FDA statement.

Philip Morris, the company behind Marlboro cigarettes, describes these alternative products as heating rather than burning tobacco, which a cigarette does. Burning tobacco, which reaches 600 degrees Celsius, “contains high levels of harmful chemicals,” according to the company’s website. The tobacco heating system (THS) heats tobacco to 350 degrees Celsius.

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“However, THS is not risk-free and delivers nicotine which is addictive,” the site says. Philip Morris has turned its focus to the IQOS product, with Philip Morris’ Chief Operating Officer Jacek Olczak saying at the Deutsche Bank dbAccess Global Consumer Conference last month that the company is committed to “working towards realizing [the] potential of this opportunity,” according to a FactSet transcript.

The development comes at a time when Philip Morris is preparing for the end of cigarette sales.

“I am convinced that it is possible to completely end cigarette sales in many countries within 10 to 15 years, but for that to happen, manufacturers and governments need to work in the same direction,” said André Calantzopoulos, chief executive of Philip Morris, in a letter to stakeholders published with the company’s report on its environmental, social and governance (ESG) efforts.

Calantzopoulos notes the “skeptical stakeholders” like international organizations and the media that “doubt that harm reduction through smoke-free alternatives is sound public health policy or argue that our purpose-driven strategy is nothing more than window dressing.”

He highlights other areas where advice to reduce a hazardous activity is accepted, such as lowering sugar intake for better health.

“I feel strongly that people who smoke cigarettes, the most harmful nicotine-containing product, should not be denied the opportunity to switch to better alternatives,” Calantzopoulos wrote.

In 2019, Philip Morris sold 706.7 billion cigarettes, down 4.5% from 2018, according to a June CFRA report. Over the next few years, CFRA forecasts that cigarette consumption will fall 3% each year.

Shipments of heated tobacco products, on the other hand, soared 44.2% to 59.7 billion units in 2019.

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There had been discussions about merging Philip Morris and Altria Group Inc.

, however those talks ended without a deal. This is a good thing for Philip Morris “given heightened regulatory and legal headwinds surrounding e-cigarettes in the U.S., as Philip Morris’ IQOS product underwent a lengthy FDA review process before getting the green light for sale in the U.S. in April 2019,” CFRA said.

CFRA rates Philip Morris stock buy with a 12-month price target of $95.

“Despite declining cigarette consumption in developed markets, we look for pricing gains and growth in emerging markets to support revenues,” CFRA said. “We think the launch of Philip Morris’ heated tobacco product, IQOS, will lead to market share gains and help offset cigarette volume weakness.”

The company reported earnings and revenue that beat expectations in the most recent quarter. The stock is down 15.1% for the year to date while the Dow Jones Industrial Average

has fallen 9.3% for the period.

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While the cigarette business was hurt by restrictions imposed by coronavirus-related lockdowns and plummeting duty-free demand at global travel hubs, Olczak said on the April earnings call that device and heated tobacco sales were showing the potential to regain pre-COVID momentum.

Philip Morris’ goal now is to move into a “smoke-free future,” said Huub Savelkouls, the company’s chief sustainability officer, in a post on LinkedIn. Philip Morris has cut its cigarette portfolio by more than 700 SKUs (stock-keeping units) over the last four years and aims to move 40 million smokers of its cigarettes over to smoke-free products.

Savelkouls says engagement, including between the company and the investment community, is needed to achieve change.

“Making cigarettes obsolete can be achieved much more rapidly through inclusivity and openness,” Savelkouls wrote. “Our goals are really not that different and that is where the potential for creating impactful change lies: working together towards making the world smoke-free.”

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Philip Morris: Mr. Market Has Afforded Yet Another Opportunity – Philip Morris International Inc. (NYSE:PM)

The recent volatility of the market has taken few prisoners. Stocks across the board have plummeted as the indices enter bear market territory. We have written about tobacco giant Philip Morris International (PM) frequently in the past. We feel that the time is right to bring attention to this name once again. Simply put, the company had a strong recent quarter – just before “stuff” hit the fan in the markets. The stock has now been pushed into the low-mid $70s again. While that is a value on its own merit, we see the economic environment in the US potentially pressuring the US dollar. If the US dollar weakens, it would provide a massive tailwind to Philip Morris, meaning that the stock’s time in the low $70s may finally be running out. We will highlight four foundational points of why Philip Morris is attractive today.

Strong Operational Performance

The company closed out its 2019 fiscal year by releasing Q4/full-year earnings in early February. The company sells a portfolio of cigarette brands, led by Marlboro in global markets excluding the United States and China. Tobacco is a resilient product category, the highly addictive nature of cigarettes allows for companies such as Philip Morris to increase prices to help stave off the secular declines of smoking rates. These declines typically result in an annual decline in total shipment volumes for cigarette makers – again, compensated for with price increases.

Given these characteristics, you want to monitor the relationship of volume declines to price increases. Philip Morris for example saw net pricing increase 6.5% for 2019. This is in line with the company’s 10-year average. This is against combustible volume declines of 4.5% (a net positive). When you factor in the continued rapid growth of HTU volumes, the total shipment volume declines to just -1.4%.

Source: Philip Morris International

The continued growth of IQOS has helped backfill the secular decline of combustible cigarettes and enabled Philip Morris to achieve high-single-digit revenue growth (excluding FX). IQOS now contributes 18.7% of total revenue for Philip Morris and is the key growth driver moving forward as the company strives for “a smoke-free future”.

Source: Philip Morris International

IQOS continues to roll out in new markets, embolden its footprint in existing markets, and is now beginning roll out in the United States under a licensing deal with sister company Altria Group (MO). Given the slow burn available in most developing markets (where regulations are minimal), IQOS is being afforded plenty of time to come into its own. Management has reaffirmed its forecast for the business to grow at a 5%-8% rate through 2021. It remains to be seen if this is altered in response to potential disruption from the Coronavirus.

Tobacco is a remarkably defensive product, however, so it should fare better than most consumer products against containment efforts in countries with Coronavirus outbreak. It’s difficult to quantify the risk to Philip Morris, as disruption would depend on the degree of global outbreak, and the severity of containment measures. A complete shutdown like what has happened in Italy would obviously be most damaging. Although in these instances, it would make sense that smokers would stockpile tobacco. We see a similar phenomenon in the US as consumers are cleaning out grocery stores in anticipation of quarantines.

The Dividend

As yields continue to evaporate from Treasury notes, stocks paying big dividends such as Philip Morris become increasingly attractive. Shares of Philip Morris are currently yielding 6.1%, nearly the highest yield the stock has offered since being spun off from Altria. With 10-year notes yielding less than 1%, this is an enormous disparity.

Source: YCharts

The defensive nature of the tobacco business should result in manageable dips in operating performance in the face of this outbreak. However, investors should note that Philip Morris has a very high dividend payout ratio. The company distributed all of its 2019 reported earnings (doesn’t include adjustments or FX) as dividends. However, the company’s cash flows cover the dividend payout more sufficiently at 79%. A high payout ratio is typical of tobacco companies, and should softer operating performance pressure the dividend payout, Philip Morris currently holds $6.86B in cash – enough to cover the dividend for more than a year. Investors should feel confident in the company’s ability to afford this high-yielding payout.

The Dollar Could Be Starting To Weaken

Another variable to keep an eye on is the strength of the US dollar. Should the US dollar begin to weaken, it would provide a tailwind to Philip Morris. The company generates virtually all of its revenues internationally, and then converts them to USD for reporting.

Source: YCharts

A strong dollar has been something Philip Morris has dealt with for years, and a reversal of this trend would only help buffer the company from potential disruptions from the outbreak.

Valuation Is Compelling

While many stocks have retreated from levels of overvaluation in this newly formed bear market, some stocks such as Philip Morris have only become increasingly undervalued. Shares have pulled back into the low-mid $70s, a level that has been hit only a handful of times since 2012.

Source: YCharts

This share price results in an earnings multiple of just 14.4X 2019 adjusted EPS of $5.19. This multiple is 16% below the stock’s 10-year median PE ratio of 17.2X.

If we look at the current yield on free cash flow, the current figure of 7.7% is also at the high end of its multi-year range.

Source: YCharts

Philip Morris is once again trading at an attractive level despite its success with IQOS and long-term runway of strong profitability through combustible cigarettes. Safety in investments is important in such a volatile environment, and we feel that the company’s balance sheet is sufficient to continue supporting its high-yielding dividend. Long-term investors are bound to benefit from capital gains as eventual PE expansion is encouraged by a strong underlying business model.

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Disclosure: I am/we are long MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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