Wednesday, July 29, 2009

Philip Morris International versus Altria

Back in 2008 Altria (MO) spun off its global tobacco operations in order to reduce litigation risk. The global tobacco operations are touted as a growth play on emerging markets such as China and Russia. Just because there might be an opportunity for growth, does not really mean however that this growth would materialize. Check my analysis of Altria Group (MO).

While the US is a mature market, where smoking is a habit where a continuously lower percentage of the population is engaging in, the current legislation has created an environment where it is virtually impossible for new players to enter. That way tobacco companies like Altria (MO) could raise prices almost indefinitely in an effort to combat tax increases and decline in demand. Another way that Altria is dealing with this issue is by acquiring competitors in niches it has little presence, as well as streamlining its efficiencies in order to cut costs to the bone. Excise taxes represent a very high percentage of the price of a pack of cigarettes. Thus Federal and State governments have it in their best interests not to ban the use of tobacco products.

However just because Altria is supposed to be a slow growth company and Philip Morris International (PM) is supposed to be growing its EPS at 10-12% annually, does not mean that Philip Morris International would be a better investment over the long run. Investors, who get excited about future growth, tend to bid up the prices of such assets. Risks to this strategy include failures to the realization of the future growth. Thus buying a stock at inflated valuations simply because one expects growth to continue forever might produce inferior long-term returns, relative to the slower growth asset. Philip Morris International (PM) is on my Best High Yield Dividend Stocks for 2009 list.

Some of the risks for Philip Morris International are that the legislation at some of its large markets like Turkey has some catching up to do. Most recently the country banned smoking outdoors in places like bars and restaurants. If other promising “growth” markets catch up and increase the regulatory burden on tobacco products, Philip Morris International operations could end up spotting similar growth prospects to Altria’s domestic operations. Altria has it easier than PMI, since it mainly has one national government to deal with; with PMI, although the operations are diversified globally, it could end up dealing with several governments all at once catching up to increase hurdles for the company.

Another risk for Philip Morris is tobacco smuggling. In some emerging markets it is “relatively easy” for third parties to sell smuggled products at lower prices or to sell “counterfeit” products. Such products erode tobacco conglomerates market shares and could lead to further increases in taxes.

PMI generates almost 47.5% of its revenues and 45.4% of its operating profits from the European Union. 23.30% of its Revenues and 29.90% of its operating profits are derived from the Eastern Europe, Middle East and Africa region. Asia and Latin America account for 19.2% and 10% of revenues respectively. The former accounted for 19.70% of profits while the latter accounted for only 5% of profits in 2008. While the EU market is mature like the US one, the positive for PMI is that it has a growth kick. If you add in strategic acquisitions and cost initiatives, there is not wonder investors increasingly favor PMI over MO. The data is from Philip Morris International's 2008 Annual Report. (source)

Altria Group has business interests that range beyond tobacco, whereas PMI is mainly concentrated on tobacco products. Altria owns a 28.5% interest in UK based SAB Miller, which is not only the second largest brewer in the world, but also one of the largest bottlers of Coca Cola (KO) products worldwide. Altria could further grow by expanding in other “related” industries such as beverages or food production. PMI could also expand significantly by purchasing leading tobacco companies in different countries. This could provide quick increase in market shares for the company. Altria also owns Ste. Michelle Wine Estates, which is the fastest growing premium top-ten wine producer in the United States.

Over the past 5 years, PMI managed to increase its earnings per share by 53%, while Altria only managed an 18% raise.

At the same time PMI also delivered strong revenue growth of 60%, much better than Altria’s paltry 8%.

Since 2004 the annual EPS growth for PMI stands at 11.20%, and 4.30% for Altria. The cost initiatives that Altria has undertaken have paid off ok, as the US tobacco conglomerate revenues rose only by 2% per annum, while PMI’s revenues rose at a rate of 12.60% per annum.

Overall I am bullish on both stocks, but I do not have a preference for either one of them. While the past 5 years have been great for Philip Morris International, negative legislation could tamper growth in the future. I do like the economics of tobacco businesses, as it costs very little to make cigarettes, which are then sold at much higher prices to the consumer. The product is addictive but there's also an incredible loyalty to brands like Marlboro.

Full Disclosure: Long PM, MO and KO

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