The Best Value in This Industry

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Though I'm aware that some investors will not invest in "sin stocks," Peter Lynch once said that a perfect investment would be a company that produces a product that customers have to buy over and over. He specifically mentioned Altria (NYSE: MO), previously known as Philip Morris, as an ideal investment, because of the addictive nature of its products. If you can get past the negative connotation of the cigarette industry, there is one stock that appears to stand out from the rest.

I've actually called this company out in the past as a stock that nearly chooses itself because the numbers are so good. While the shares are more expensive than when I originally looked at them, Philip Morris International (NYSE: PM) is arguably the best value in the industry. The company's most recent earnings wouldn't appear to support the suggestion, but you have to understand the significant effect that international economic turmoil has on the company's results. While revenue was up 3.4%, adjusted diluted EPS increased just 0.7%. If you exclude the effect of foreign exchange, EPS would have increased 5.8%. When you consider that overall cigarette volume decreased by 1.3%, and the industry saw declines in eight different European union countries, these results are actually pretty impressive. When you look at the company's results on a geographic basis, you can clearly see how well Philip Morris would have done without the effect of foreign exchange.

Phillip Morris' geographic results are somewhat split between countries that would have done very well excluding foreign exchange and Europe. For instance, the company's second largest market is their Eastern Europe, Middle East, and Africa division. In this market, revenue was down 0.1%, but excluding foreign exchange, revenue would have increased 9.4% on a volume increase of 3%. Another area of the world where foreign-exchange made a big difference was in Latin America and Canada. Though this division is smaller, foreign-exchange had the effect of changing 7.3% revenue growth into a decline of 2.4%. In another example, the company's Asian market saw foreign-exchange take revenue growth of 2.4% and turn it into a decline of 1.4%. Last but not least, it should be no surprise that the European Union was the most challenging division, given the turmoil over the last year or so. With reported revenue down 15.2%, excluding foreign-exchange revenue would've only been down 1.9%. Given that the unemployment rate in the European Union is estimated to be about 10%, Phillip Morris is actually weathering the storm fairly well. One of the primary differences between Phillip Morris International and most of its competition is their international concentration, as opposed to the more heavily regulated domestic market.

In the domestic market, there is certainly no shortage of competitors, including the likes of Altria, Lorillard (NYSE: LO), and Reynolds American (NYSE: RAI). Though none of these companies compete directly with Philip Morris International, it's instructive to look at their dividends and free cash flow to get an idea of the strength of this company. Each of the domestic producers has one advantage over Philip Morris International, and that is their dividend yield. All three of these companies pay dividends of at least 5%, and with one exception, their free cash flow payout ratios are actually lower than Philip Morris International as well. Since many investors purchase the shares for the dividend, take a look at the comparison of Philip Morris International versus their three domestic counterparts:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>FCF Payout</strong></p> </td> </tr> <tr> <td> <p>Altria</p> </td> <td> <p>5.26%</p> </td> <td> <p>38.49%</p> </td> </tr> <tr> <td> <p>Lorillard</p> </td> <td> <p>5.03%</p> </td> <td> <p>36.06%</p> </td> </tr> <tr> <td> <p>Philip Morris Int.</p> </td> <td> <p>3.76%</p> </td> <td> <p>60.93%</p> </td> </tr> <tr> <td> <p>Reynolds American</p> </td> <td> <p>5.48%</p> </td> <td> <p>115.00%</p> </td> </tr> </tbody> </table>

As you can see, Philip Morris International neither has the highest dividend yield, nor the lowest free cash flow payout ratio, so you may wonder why I would think this company could represent the best value. The primary reason has more to do with the future than what's happening today.

In the domestic market, everyone knows that cigarette volumes consistently decline. The industry combats this decline by raising prices and cutting costs. Internationally there is a different dynamic, as many countries see volume growth. This is a critical difference between domestic and international tobacco companies, as Philip Morris can increase earnings from organic growth as opposed to cutting costs and raising prices. A second reason Philip Morris might be the best value in the industry comes from a counterintuitive look at the company's gross margin. Philip Morris reported a recent gross margin of just over 27% versus its domestic counterparts showing gross margins of 36% to as much as 50%. While at first this would seem to be a disadvantage, what it tells investors is that Phillip Morris is keeping its pricing reasonable while it expands. However, in the future, the company should have the opportunity to increase prices in the way its domestic competitors have. Last but not least, Philip Morris should be able to increase its dividend at a greater rate than its domestic counterparts. Analysts are calling for EPS growth of over 10% in the next few years. By comparison, the fastest growing domestic producer is Lorillard, which is expected to grow by about 8.7% in the same time frame. If investors need further proof that the company believes that its shares are a good value, consider that management just authorized a share repurchase program of $18 billion. With management raising the dividend, buying back shares, and good organic growth, this “sin stock” seems like a great value.


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