Is this Tobacco Company Overrated?
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The recent decision of Goldman Sachs to raise the rating of Philip Morris (NYSE: PM) to a buy along with a target price of $103 per share isn’t surprising. After all, the strong fundamentals of the company along with its potential growth in East Europe and Asia make Philip Morris a very reasonable investment. Nevertheless, I think it's worth noticing not only its main strong points, but also some potential risk and uncertainties that could impede the progress of this company and curb the growth of the stock price in the near future. Let's examine these issues.
Europe, Taxes and Currencies Risk
The European region accounts for almost 30% of Philip Morris's revenues. During the first nine months of 2012, the company's net revenues have declined by nearly 7.7% in this region and earnings have decreased by nearly 8.9%. The main reason for the drop in revenues was the unfavorable changes in currencies. This means, the currency fluctuations are one of the prime uncertainties that the company is facing. In comparison, Altria (NYSE: MO) solely operates in the U.S and doesn't face such uncertainty.
Even after controlling for the currency fluctuations, Philip Morris's revenues inched up by only 0.6% in the first three quarters of 2012 in Europe. This modest growth could be the result of three main factors: economic slowdown, a rise in Excise Taxes on products, and competition. The EU isn't showing signs of progress and its macro-economic conditions aren't likely to improve in the near future. This could further curb the growth of the demand for tobacco products. In regards to competition, Philip Morris doesn't have a strong hold on the European market as Altria has on the American market. The strong competition comes from companies such as British American Tobacco (NYSEMKT: BTI) and its Kent brand. Finally, the high taxes on cigarettes account for nearly 69% of the total revenues of the company in 2012; if the EU will raise taxes on tobacco products this is likely to impede the progress of Philip Morris.
But the main driving force of the company is expected to come from Asia and the EEMEA regions. So let's examine these regions.
Progress in Asia and EEMEA
During the first three quarters of 2012, the company's revenues grew in Asia and EEMA by nearly 4.2% and 4.8%, respectively. Moreover, these regions account for nearly 26% and 36%, respectively, of PM's revenues. It's worth noticing several issues: Even though the percent of taxes out of the total revenues in these regions is much lower than in Europe, it is still a high percentage (around 57% for EEMA and 47% for Asia). If the governments in these countries will decide to raise taxes on cigarettes, this could adversely affect the company's growth in sales. For EEMA, the currency risks did curb the growth in revenues by nearly 7 percentage points in the first nine months of 2012. In other words, without the currency fluctuations the revenues in EEMA would have grown by 11.8%. The profit margin in Asia and EEMA is lower than in Europe despite the higher taxes in the latter. Finally, the macroeconomic conditions in Asia including China and Japan are unclear. China is showing some signs of growth but not in the same pace as in the pre-2008 financial crisis. Japan's new government is trying to pull its economy out of its slowdown.
So even though Asia and EEMA are likely to keep pulling up the company's revenues, the company is facing certain risks as uncertainties that could curb the growth in these regions.
Cash Flow Dividend and Loans
Let's turn to some of the company's strong points: The Company has been buying back its stock; in the first nine months of 2012 PM has purchased nearly $4.5 billion of its stocks. In exchange, the company's debt grew by nearly $3.9 in the first three quarters of 2012. Furthermore, the recent news is that the company is seeking another $2 billion loan for a year. This switched of capital for debt seems reasonable considering the historically low interest rates. As long as the company will continue on this direction and the Fed will keep dragging down the long term interest rates, this could result in huge saving. PM is paying an annual dividend yield of nearly 3.8%. For a loan, the company is likely to get an annual rate of Libor +15bp, which comes to around 0.95%; thus the company will save nearly 2.8% per year by replacing equity for debt. In dollars, this means for every $1 billion of switching stocks for debt, the company will save an annual payment of nearly $28 million per year.
The company is capable to payoff its dividend by its free cash flow (the sum of operating and investing activities). In the first nine months of 2012, the company's free cash flow reached $7 billion, which was more than enough to pay its $3.9 billion dividend. In comparison, other leading tobacco companies offer higher dividend yields but their payment is at a higher risk because their free cash flow isn't enough or just barely sufficient to cover the dividend payments: Altria is paying a dividend yield of 5.26%. But the company has a free cash flow (as of the first nine months of 2012) of nearly $2.8 billion, which is just enough to cover the company's dividend payment of $2.5 billion. Reynolds American (NYSE: RAI) is offering an even higher dividend yield of 5.46% based on a quarterly dividend payment of $0.59 per share. The free cash flow of Reynolds was around $887 million in the first nine months of 2012, while the dividend payment was $977 million. So Reynolds wasn't able to cover its dividend payment with its free cash flow. British American Tobacco is another leading tobacco company and a direct competitor of Philip Morris. BTI paid a dividend of 1.36 GBP per share, which is nearly 4.1% yearly yield. In the first half of 2012, the company's free cash flow of 1.166 billion British pounds wasn't enough for paying its dividend payment of 1.723 billion British pounds.
So even though Philip Morris is offering a slightly lower dividend yield than other leading tobacco companies, at least the payment is less risky in PM than in those other tobacco companies.
Don't get me wrong, I still think PM is very solid investment with potential growth in Asia and EEMA, but one should also consider the risks and uncertainties that the company is facing that could impede its progress.
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Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.
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