By Michael Brush
Opinion: Tobacco stock has been beaten down enough
-Michael Brush; 415-439-6400; AskNewswires@dowjones.com
For a contrarian investor, few companies can get the juices flowing like one with a product considered so venal that it's banned in much of New York City.
I'm talking about cigarettes -- now so despised that even fiercely independent New Yorkers accept a prohibition on smoking in public.
This kind of negativity helps explain why the stock of one of the companies that's best at selling smokes, Philip Morris International (PM), has dropped sharply in recent weeks -- and now looks quite buyable.
Of course "best" here means that Philip Morris does a great job of selling a product that is highly addictive and unhealthy. If that makes you queasy, take a pass. If you believe in free choice, though, this is a good name to put in your portfolio right now -- for market outperformance, and a solid 4% dividend yield.
Sure there are problems, like the widening global ban on smoking in public, most recently in Russia, and the growing popularity of e-vapor cigarettes, which seem healthier. Global cigarette sales, by volume, continue to decline because of these trends.
But here's the key. Philip Morris has been warning about these trends all year, and by now they seem priced in. Second-quarter results in mid-July suggest the run of fresh bad news may be over. "Our key takeaway is that the absence of any new issues results in less risk," says Morgan Stanley's David Adelman, who has a "buy" rating on the stock.
That makes this a good time to buy Philip Morris. After all, this is a company with some of the most powerful brands in the world. It will continue to post earnings growth of 6%-8%, because it can use that power to raise prices.
Philip Morris has the global rights (ex-U.S.) to Marlboro, L&M, Philip Morris, and Chesterfield, among others. Altria Group (MO) kept the U.S. rights to those brands when the two companies split up in 2008.
I also like the insider buying here.
Of course, investors see big problems, or they wouldn't have knocked this stock down 9% in the past six weeks. But the fears seem misplaced. Let's take a look.
Problem # 1: Philip Morris has warned that higher costs will hit margins in the second half of 2014, a challenging time anyway because year-ago results were so strong they're hard to beat.
But these are just temporary headwinds. To me, it makes sense to take the other side of the trade when investors keen on instant gratification leave stocks for short-term reasons.
Besides, costs are going up for the right reasons. Philip Morris is investing in an alternative cigarette called HeatSticks, which heat rather than burn tobacco. This should be a big source of profits in three to four years. The company is also funding the rollout of a refreshed version of Marlboro Reds (new pack and filter design), and a shift in manufacturing to lower cost South Korea. I'm OK with costs that pay off, medium term.
Problem # 2: Sales trends are terrible in key markets like Japan, the Philippines, Indonesia and Australia.
True, but sales are weak for reasons that won't likely worsen near term -- tax increases, and the move towards plain packaging in Australia, which cuts into Philip Morris' brand power. In contrast, Philip Morris posted nice growth in Latin America, Canada, Europe, Eastern Europe, the Middle East, and Africa.
A big part of the gains came from price increases, thanks to that brand clout. Second-quarter cigarette sales declined 2.7% by volume, but the company netted an extra $494 million anyway, from price hikes. Despite the price hikes, Marlboro gained share in most markets.
Medium term, this is an emerging middle-class play since people trade up to premium brands when they make more money, notes Morningstar analyst Philip Gorham.
Problem # 3: The company can't keep taking price increases forever.
Actually, it has room to do just that, maintains Jason Benowitz, who follows cigarette companies as senior portfolio manager at The Roosevelt Investment Group, which has $4.5 billion under management. Philip Morris takes about $1.8 billion in price increases a year. But since 2009 its cigarettes have gone up in line with another major global consumer product, the Big Mac, says Benowitz.
Problem # 4: E-vapor cigarettes, considered healthier, are a threat.
Sure they are popular, but they have one big problem -- they don't deliver the kind nicotine hit that regular cigarettes offer. That's one reason why e-vapor cigarettes won't take much market share medium term, says Benowitz. Besides, Philip Morris has an edge in this market since it has more financial firepower, a huge distribution system, and more experience dealing with regulators than the upstart companies developing the e-vapor market, he says. E-vapor cigarettes could actually be a plus.
The bottom line: Morgan Stanley's Adelman has a $92 price target on this stock. That 10% gain plus the 4% dividend would net you 14% over the next year. Gains in stocks overall may be more limited from here, given the huge advance of the past four years. So that 14% may well turn out to be a market-beating return -- in a name that's probably going to be safer in any corrections.
Also read these stories:
4 myths about Amazon stock that investors should ignore
29 state AGs urge tougher curbs on e-cigarettes
-Michael Brush; 415-439-6400; AskNewswires@dowjones.com
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08-11-14 1113ETCopyright (c) 2014 Dow Jones & Company, Inc.