Tobacco's Most Profitable Business Could Expand Margins Further

Unfavorable currency and trade inventory movements caused noise in  Philip Morris International's (PM) first-quarter earnings report, masking the structural advantages that we think should allow the firm to earn excess returns on capital in the long term. The company is on track to meet our full-year forecasts, and we do not intend to adjust our $90 fair value estimate. We also reiterate our wide Morningstar Economic Moat Rating, although we remain concerned that plain packaging is a threat to Philip Morris' competitive advantages.

Reported revenue fell 4.0%, largely because of unfavorable foreign exchange movements, slightly ahead of our full-year estimate of a 4.4% revenue decline. Even excluding currency, however, revenue (down 1.6%) and operating income (down 3.1%) declined as Philip Morris failed to offset lower volume with higher prices. We do not think this is indicative of the long term, and we believe Philip Morris' wide moat, particularly through its brand strength, should allow it to increase revenue at a mid-single-digit rate in the long term.

In the first quarter, unfavorable inventory movements in Japan affected volume and cyclical macroeconomic factors continued to weigh on pricing. However, we were encouraged to see some stability in the European Union, with volume down 3% (in line with long-term trends and a sequential improvement from the 6.5% decline in 2013) and revenue essentially flat in the first quarter.

Improving Operational Efficiency Could Send Margins Higher
Philip Morris International is one of the strongest businesses in our consumer defensive coverage. The company generates industry-leading operating margins in the low 40s and boasts a wide economic moat with strong brand loyalty and cost advantages at its core. Nevertheless, we see room for executional improvement, and we think margins could go even higher.

Philip Morris' profitability in emerging markets is a key differentiator from competitors, and the firm has a strong presence in Asia. The advantage of selling in emerging markets is that volume is more stable and, in some cases, increasing. Indonesia (where Philip Morris has about a 31% share), Turkey (about 45%), and the Philippines (about 90%) are all growing in volume at a low- to mid-single-digit rate as a more lax regulatory environment in those regions has led to higher levels of smoking initiation. This should help to slow the firm's decline in volume over the next decade. The disadvantage of emerging markets is that on the whole, they are less profitable than developed markets. This is less true for Philip Morris International than it is for its competitors. It generated a 2013 EBIT margin of 43% in Asia, only modestly below the 44% group EBIT margin and 300 basis points above that of British American. The Asia segment margin is skewed by the firm's strong presence in the profitable Japanese market, but it also reflects Philip Morris' positioning in premium categories.

An opportunity for margin expansion lies in improving operational efficiency, and we would like to see management focus on optimizing its manufacturing processes. Since its creation in 2008, the firm has consistently operated with less efficient asset turnover and cash conversion ratios than its competitors, despite its greater scale. We believe there is some fat to trim in the cost structure, including consolidating manufacturing plants; we estimate that bringing the firm's asset turnover ratios in line with competitors could add $800 million or 200 basis points to the EBIT margin.

Loyal Customers Dig a Wide Moat
Powerful intangible assets are at the core of Philip Morris' wide economic moat. In addition, the company's platform of total tobacco products and e-cigarettes gives it economies of scope and scale that make it difficult for new entrants to gain the critical mass of volume necessary to compete. Finally, the addictive nature of tobacco products makes demand fairly price-inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.

Tobacco brands' intellectual property has created loyalty among tobacco users toward the brands they enjoy. Philip Morris has an impressive brand portfolio that is evenly balanced across price points. Despite the advertising ban on tobacco products in many developed markets, brand identity through product differentiation and trademarks allows manufacturers to charge premium prices for their products. In fact, it is the bans on advertising that help to keep market shares stable and new entrants out. Philip Morris' leading brands include Parliament, Virginia Slims, and Chesterfield, and the firm also offers the only truly global and highest-volume brand, Marlboro. The company is the largest cigarette manufacturer outside China and is the only one of the largest four players (excluding China National Tobacco) to increase its market share (by 30 basis points to 16%) since 2008.

Historical returns on invested capital support our wide moat rating. Philip Morris has generated returns on invested capital in excess of 30% since splitting from Altria in 2008, and ROIC has increased steadily over that time to around 45% in 2013. We forecast returns to remain at 45% over the next decade, comfortably ahead of our 9% estimate of the firm's weighted average cost of capital.

Industry Fundamentals Remain Stable
Our fair value uncertainty rating is low. Evidence from the recent economic volatility suggests that industry fundamentals--and, therefore, manufacturers' cash flows--remain stable. With pricing power intact, the greatest operational risks, in our view, are the risk of plain packaging measures in large markets and foreign exchange risk.

Any investor owning tobacco stocks should have the stomach for fat-tail risk. Although the businesses are stable, the threat of government intervention through large excise tax increases, for example, is omnipresent. Litigation risk is substantially lower for the European players, as most countries do not have a class-action legal process. Nevertheless, we regard government and legal risks as low-probability events with high potential impacts that investors should be aware of.

In general, we believe government regulation does little to affect the economic moats or cash flows of tobacco manufacturers, and in some cases, regulation actually limits competition, lowers costs, and strengthens pricing power. Plain packaging is different, though, because we believe it could facilitate trading down, which would erode pricing power and be detrimental to moats in the industry. The most likely large market to follow Australia in introducing plain packaging is the United Kingdom, where Philip Morris has only a small presence, but if plain packages are introduced in any other major EU market, this could be materially detrimental to the firm, given its positioning in premium categories.

Philip Morris' functional currency is the euro, but it reports in U.S. dollars. It also has exposure to currencies too small to hedge in large amounts on the open market. Although it has something of a natural hedge, with about 26% of its costs in euros almost offsetting the 32% of its revenue denominated in euros, strength in the U.S. dollar can have a significant and detrimental impact on Philip Morris' earnings.