New Purchase: Philip Morris (PM)

*First an addendum. I don’t talk about most positions in my portfolio. Reading the current posts of stocks is in no way a representation of my entire portfolio.

As I’ve mentioned, I’m a fan of sin businesses, that have incredible ROI, requiring exceptionally minimal capital in order to produce amazing cash flow and gains. This was evident when we talked about Diageo (DEO) and though I didn’t talk much about my purchase process, I did discuss my ownership of Lorillard (LO) and the power of dividend reinvestment.

I recently picked up a 1/3 to 1/4 of a position in Philip Morris (PM).

Thesis

I’m not going to spend a huge amount of time explaining every nuance of PM, that’s what their website is for. What I will say, is that they are currently on sale. The stock has been beat up the past year due to some weak guidance and earnings. However, the fundamentals of the company haven’t changed a bit. Sales and EPS on a currency neutral basis are up. They’re simply being punished because their sales are in foreign currency, while their financials and dividends are in USD.

It’s very silly to buy or sell a company because currency valuation is currently favorable or unfavorable to a particular business (excluding major collapses). The dollar was weak against the Euro for a decade. Now we seem to be best house in a bad neighborhood. It’s not a reflection on the fundamentals of Philip Morris. Oftentimes it’s a huge advantage to have your revenue coming from a basket of foreign currencies. At some point in the future this trend will reverse and suddenly PM will appear vastly more valuable than it’s current price implies.

So why do I like Philip Morris? It’s not that complicated. They generate so much cash flow it’s obscene. Like most of my other individual holdings, PM has strong brands and a product that requires low capital expenditures and relatively low operating costs. They are also in a strong position to control pricing power. They create vast amounts of wealth from an incredibly small amount of capital.

Basically, PM prints money. Because this isn’t a growth  market, that cash flow only has one place to go, back to my pocket and yours through share repurchases and dividends.

This type of purchase isn’t going to be a homerun. It’s not going to double or triple in the next 5 years. It may even be bad timing if the dollar rises further. However, since I’ll set this purchase to DRIP, I’ll be buying additional shares every time those dividends hit (and likely take the other 2/3 of a pull position).

If I purchased a theoretical 100 shares (75.33 x 100), I’ll end up with $400 in dividends each year, which buy an additional 5 shares (assuming prices stay static). The compounding power of those purchases only gets better if prices drop from here. I expect when I look at these numbers in 10-20 years, it will be pretty shocking what it’s managed to turn in to, particularly with zero transaction fees and no management fees coming off the top.

As usual, I always mention when discussing tobacco companies, that I believe included in the price is a very cheap, way out of the money call option on huge growth if the trend toward the legalization of marijuana continues.

Now that the general thesis is covered, let’s look at a few details.

Financial Health

Free cash flow has floated between $6-9 billion over the past 5 years. The company is predicting a strong 2015, with EPS between $4.27 and $4.37, with a currency impact of $1.15. 2015 EPS guidance is strong with growth in adjusted EPS of 7.8%. This more than sufficient to maintain the dividend and manage the Companies debt load. Personally I hope they don’t get overly aggressive in 2015 on either buybacks or dividend increases and let that number come down a bit until we see currency issues come back more in line.

Price

The stock is down 22% from its April high of $96 and off around 16% from the July 2014 high. The Company has certainly not performed well in comparison to the S&P which has seen substantial gains in that time period.

The Company is currently trading at around 15-16 times earnings, which I find reasonable compared to both their peers and their historical ratios.

Buybacks

PMI has spent $12.7B of its $18B share repurchase program, to repurchase. I actually hope they give this a rest for 2015.

Dividends

 

PM increased its dividend during 6.4% in 2014 to $1.00 for an annualized rate of $4.00 per common share. PM has increased its dividend 117.4% since the initial spin-off. Those are the kind of numbers I like to see.

At $4.00 per share and a share price of $75.33, that’s a yield of 5.3%. That is incredible in the current era of 0% interest rates.

The payout level is a concern, as it’s near a peak of 80.5%, however this is highly reflective of the current currency issues. A slight decline in the dollar would bring this down in to a very acceptable level.

Cost Reductions

PM has continued to search for cost reductions, shuttering certain facilities in the Netherlands, Canada and Australia. In 2014, PMI exceeded its one-year gross productivity and cost savings target of $300M.

Debt

The biggest drawback I see is the Companies debt load. Debt has increased over past few years, with current and long-term debt totaling almost $30B.

However the Company has managed to lock in notes that are largely 5% with very long maturities that should not be an issue.

Brand

PM gained a further 0.3 market share for a total of 28.6% and holds the number 1 or 2 positions in 29 out of the 40 largest markets.

 

Currency Breakdown

Company has been pounded by currency issues, particularly in Russia. However hedges are in place for a large percentage of volumes and the company is naturally hedged to a large extent as a large percentage of costs are local to each market. Other major currency impacts were caused by the Euro, Yen and Indonesian Rupiah. These four currencies account for approximately 42%, 13%, 11% and 5%, respectively, or over 70% collectively, of the total unfavorable currency variance. At prevailing exchange rates, the adverse currency impact on our 2015 net earnings would be approximately $1.7 billion

Risks

I think I’ve discussed currency sufficiently, but it’s worth noting that if the dollar continues to increase versus PM’s primary market’s this could cause some concern.

In addition, Plain Packaging requirements continue to be put in around the world which could impact sales.

The Company also needs to keep a close eye those debt levels.

Management Statements

“We are also fully committed to returning around 100% of our free cash flow to our shareholders.We remain steadfast in our determination to offer an attractive dividend to our shareholders, while maintaining the benefits provided by our single-A credit rating in terms of financial flexibility and preferential interest rates.”

This is the kind of thing you want to hear from management that is focused on shareholder return.

Here is the thesis back to you from PM management themselves. I can’t say I disagree with any of it.

Conclusion

Philip Morris demonstrates all the hallmarks of a business with staying power, even in the face of opposition to smoking and tobacco products.

They have a strong brand and moat with a product unlikely to be disrupted. The Company puts out exceptional levels of cash flow and requires minimal capital inputs.

The Company also has the type of shareholder friendly management we all hope to find.

I suggest investors take advantage of a discount due to currency fluctuations that are not a reflection on the strong fundamentals of Philip Morris. In the meantime they will be paid to wait with an impressive 5% yield and will have the opportunity to reinvest for additional shares at a discount.

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