Should You Invest in International or Domestic Tobacco Stocks?

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Philip Morris International (NYSE: PM), the second largest tobacco company in the world, recently stumbled after reporting second quarter earnings that came in below analyst estimates. The international maker of Marlboro cigarettes, which is often vilified for its heavy-handed presence in developing nations, blamed lower global demand and unfavorable exchange rates for the slowdown in its top and bottom-line growth.

Second quarter earnings were a drag

For the second quarter, Philip Morris earned $1.30 per share, or $2.12 billion, down from the $1.36 per share, or $2.32 billion, it earned in the prior year quarter. Revenue, excluding excise taxes, declined 2.5% to $7.9 billion. Analysts had anticipated earnings of $1.41 per share on revenue of $8.17 billion. Philip Morris’ total shipments slid 4% to 228.9 billion cigarettes, declining across all of its global regions. Total sales volumes of Marlboro, its leading brand, dropped 6% to 72.4 billion cigarettes.

Ever since its spin-off from Altria (NYSE: MO) in 2008, Philip Morris International has become a bellwether for international smoking trends. The spin-off left Altria exclusively in charge of Philip Morris’ domestic tobacco portfolio, as Philip Morris International handled business abroad.

Global exposure is a double-edged sword

This split business has been both a blessing and a curse for Philip Morris International. On one hand, the company is completely protected from U.S. regulators and a sharp decline in domestic smokers. On the other hand, a strong dollar has crimped its revenue growth, since it still reports earnings in U.S. dollars. In addition, macroeconomic troubles in Europe and Asia have hurt its top-line growth. Over half of the countries in the European Union, which accounts for over a third of Philip Morris’ top line, are currently in a recession.

Shipments declined 3.6% across its Eastern Europe, the Middle East and Africa region, 2.4% in Latin America, and 3.5% in Asia. The most damaging blow to Asia was a tax increase in the Philippines, which caused a 16.5% decline in shipments. Philip Morris is highly exposed to the country, due to its purchase of Philippine cigarette maker Fortune Tobacco in February 2010.

Expenses rise as revenue falls

To top off that bad news, the company’s total cost to manufacture and sell cigarettes rose more than 1% year-on-year to $2.7 billion. That unpleasant combination of slowing top and bottom-line growth, declining sales volumes, unfavorable exchange rates and higher expenses all indicate slower growth ahead.

To confirm that, the company reduced its full year profit guidance to $5.43 to $5.53 per share. However, that still comes in above its prior year EPS of $5.17 per share. Although Philip Morris’ expenses have steadily risen over the past five years, they have not outpaced revenue growth. By comparison, Altria aggressively slashed its expenses as revenue growth flattened out, as seen in the following chart.

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Are Altria and Lorillard better bets?

Some investors are probably wondering if domestic tobacco companies, such as Altria and Lorillard (NYSE: LO), are better investments than the globally exposed Philip Morris International.

<table> <tbody> <tr> <td> </td> <td> <p><span><span><span><strong>5-year PEG</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Trailing P/E</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Price to Sales (ttm)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Qty. Revenue Growth (y-o-y)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Qty. Earnings Growth (y-o-y)</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Profit Margin</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Dividend Yield (trailing)</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Philip Morris International</strong></span></span></span></p> </td> <td> <p><span><span><span>1.46</span></span></span></p> </td> <td> <p><span><span><span>17.24</span></span></span></p> </td> <td> <p><span><span><span>4.66</span></span></span></p> </td> <td> <p><span><span><span>-8.60%</span></span></span></p> </td> <td> <p><span><span><span>-2.50%</span></span></span></p> </td> <td> <p><span><span><span>27.81%</span></span></span></p> </td> <td> <p><span><span><span>3.80%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Altria Group</strong></span></span></span></p> </td> <td> <p><span><span><span>2.06</span></span></span></p> </td> <td> <p><span><span><span>17.21</span></span></span></p> </td> <td> <p><span><span><span>4.24</span></span></span></p> </td> <td> <p><span><span><span>-0.50%</span></span></span></p> </td> <td> <p><span><span><span>15.90%</span></span></span></p> </td> <td> <p><span><span><span>25.00%</span></span></span></p> </td> <td> <p><span><span><span>4.80%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Lorillard</strong></span></span></span></p> </td> <td> <p><span><span><span>1.38</span></span></span></p> </td> <td> <p><span><span><span>15.03</span></span></span></p> </td> <td> <p><span><span><span>3.72</span></span></span></p> </td> <td> <p><span><span><span>5.90%</span></span></span></p> </td> <td> <p><span><span><span>47.10%</span></span></span></p> </td> <td> <p><span><span><span>25.62%</span></span></span></p> </td> <td> <p><span><span><span>4.60%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span>Advantage</span></span></span></p> </td> <td> <p><span><span><span>Lorillard</span></span></span></p> </td> <td> <p><span><span><span>Lorillard</span></span></span></p> </td> <td> <p><span><span><span>Lorillard</span></span></span></p> </td> <td> <p><span><span><span>Lorillard</span></span></span></p> </td> <td> <p><span><span><span>Lorillard</span></span></span></p> </td> <td> <p><span><span><span>Philip Morris</span></span></span></p> </td> <td> <p><span><span><span>Altria</span></span></span></p> </td> </tr> </tbody> </table>

Source: Yahoo Finance, 7/18/2013, adjusted for PMI’s 2Q earnings

At first glance, Lorillard, the maker of Newport, Kent and Maverick cigarettes, looks like an undervalued growth stock compared to Altria and Philip Morris. However, some of Lorillard’s growth potential can be attributed to its smaller size - it currently has a market cap of $17.6 billion compared to Altria’s $74.5 billion. Philip Morris is larger than both companies combined with a market cap of $146.9 billion.

However, the domestic tobacco business is a very different one from the international one. In 2012, the smoking rate in the United States declined to 18%, down from 20.6% in 2009, according to the National Center for Health Statistics. By comparison, the smoking rate in Indonesia, one of Philip Morris’ hottest growth markets, is currently at 35%.

Smokeless tobacco, cigars and electronic cigarettes

To offset lower sales of cigarettes, Altria and Lorillard have invested heavily in alternative forms of nicotine. Altria is invested heavily in chewing tobacco through its acquisition of UST in 2009, and currently owns leading brands Copenhagen and Skoal. It has also invested in cigars, through its purchase of John Middleton Cigars in 2007, which added the popular Black & Mild brand of machine-made cigars to its portfolio.

More importantly, both Altria and Lorillard have invested in electronic cigarettes, which are a smokeless alternative to traditional cigarettes. Electronic cigarettes vaporize nicotine cartridges with an electric charge, which allows smokers to inhale nicotine vapor that lacks tobacco and tar. Although the FDA has warned that second hand smoke from e-cigarettes is still harmful, Altria recently launched its MarkTen electronic cigarette in Indiana, in an attempt to test out demand. Lorillard’s Blu eCigs brand, which it acquired last April for $135 million, is available nationwide.

Although e-cigarettes currently account for only 1% of the cigarette market, Lorillard is now the market leader, claiming a 37.2% market share in June, putting it ahead of NJOY at 33.9%. The rest of the fledgling market is fragmented among a myriad of smaller competitors.

The tables will tilt back in Philip Morris’ favor

Although some investors might think that Philip Morris International might need to introduce e-cigarettes and chewing tobacco to its global markets, I strongly disagree. Philip Morris International simply needs to wait for the economic situation to improve across Europe, its investments in Indonesia to pay off, and to continue expanding into untapped markets by buying up local brands.

<img alt="" src="" />

In other words, I believe that Philip Morris International is a cyclical stock that is merely in the low point of its growth cycle, and that long-term shareholders will still be handsomely rewarded. 

Leo Sun owns shares of Altria Group and Philip Morris International. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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