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Philip Morris: A Buy Despite Headwinds
01/24/2014 7:00 am EST
While recognizing that some investors are averse to investing in a cigarette manufacturer, Josh Peters, in Morningstar Dividend Investor, offers a top pick for those who are willing to invest in the tobacco sector.
2014 is shaping up to be a poor year for Philip Morris International (PM). Management has predicted that earnings per share—targeted to expand 10%-12% a year, before currency effects over the long run—would rise only 6%-8% next year.
Several reasons were cited: excise tax hikes in Russia, tax avoidance by a key rival in the Philippines, steps to improve market share in Japan (read: discounting), and—more promising—higher costs for developing next-generation tobacco products like e-cigarettes.
Further, management said that current exchange rates indicated an additional earnings headwind of about 7% in 2014, possibly leaving Philip Morris with no EPS growth at all.
Nevertheless, I view recent weakness in Philip Morris International as a buying opportunity.
While the follow-up punch of currency drags doesn't reflect well on management, neither disclosure had a particularly large effect on our fair value estimate, which dropped only $2 to $93 a share.
It would be very odd for a tobacco manufacturer's profits to plunge, especially for one as thoroughly diversified as Philip Morris.
However, while the company has achieved 10% average EPS growth over the past seven years, results for individual years range from negative 1% to positive 26%.
We expect EPS growth to rebound in 2015 and beyond—new products should eventually pivot from a cost drag into a source of profits. Currency headwinds won't always be so fierce; at times, currency will be a tailwind.
Moreover, we haven't assumed Philip Morris will achieve all of its 10%-12% target with currency included. Our $93 fair value points to 9% EPS growth over the next five years and mid-single-digit growth in the years beyond.
Valuation also provides a helpful form of context. Between the drop in the stock price since its April peak, and the 10.6% dividend hike announced in September, the yield on the stock has improved from 3.6% to 4.4%.
At that level, I doubt the price is discounting long-term EPS and dividend growth of even 6%, let alone our forecast of 9%.
The underperformance of the stock this year seems like a fair reflection of weak near-term prospects in a typically myopic market.
The current price provides a margin of safety against future shortfalls in growth, plus nice upside if (or when, in my view) growth gets back on track. In all, Philip Morris remains my top pick for those who are willing to invest in tobacco.
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