Philip Morris Fires on All Cylinders

Although

There are several legitimate reasons for the recent momentum in Philip Morris' stock. First, underlying business fundamentals are strong. The company achieved above-par pricing of more than 6% in 2015, while volume declined just 1%. Although currency remains a significant drag (it reduced EBIT by 20% last year), Philip Morris gained share globally, and its 6% constant-currency revenue and 11% EBIT growth represented one of the strongest underlying performances in large-cap consumer staples. Second, rumors have resurfaced recently that Philip Morris could recombine with Altria MO. We think this is likely in the long term: The United States remains an attractive market in terms of affordability, and it would reduce Philip Morris' significant currency exposure and unify control of the Marlboro and iQOS brands under one management. However, with the dividend payout ratio currently around 90% and with some leverage already from previous share buybacks (debt/EBITDA was 2.5 at the end of 2015), we think any transaction is unlikely in the near term.

We had identified heat-not-burn as the category most likely to win consumer adoption because of its mimicking of the smoking experience, and the commercialization of Philip Morris' iQOS is now drawing attention to the category's potential. The heat-not-burn platform is the first to market and is now available nationally in Japan, as well as in Switzerland, four cities in Italy, and other select markets in Europe. Consumer adoption has been mixed across these markets and has been most successful in Japan, where over half of trialists are now using iQOS for at least 70% of their tobacco consumption and iQOS has a 1.6% share (as at the end of January).

E-Cig Uncertainties Despite this success, we identify two major uncertainties regarding the adoption path for iQOS globally. First, the ability of manufacturers to make claims of reduced risk or exposure is not yet clear. Philip Morris' management has been bullish on the benefits to public health, but toxicology studies and clinical trials have not yet been carried out by independent parties. Claims of reduced risk are critical to consumer adoption, in our opinion, as the core consumer base is likely to be current smokers who must recognize tangible benefits before paying EUR 70 for the iQOS system. While it seems likely to us that the avoidance of the burning of tobacco is likely to reduce carcinogens, this has not yet been confirmed by health officials.

The second unknown is iQOS' medium-term margin, and this seems likely to be influenced by taxes. In its existing markets, iQOS is taxed as a cigarette alternative or under a new category for noncombustible tobacco products. While the retail price of the iQOS heatsticks is roughly at parity with Marlboro cigarettes, the level of taxation is lower, meaning a greater amount of the retail price accrues to the manufacturer. At full capacity, therefore, it is possible that heatsticks could be margin-accretive, as cannibalization takes place if current tax regimes remain unchanged. This is particularly true given that shifting manufacturing capacity from combustible to heatsticks should be logistically straightforward and have a fairly low capital expenditure requirement. We think the future taxation of heat-not-burn products will depend on the acceptance of reduced risk. If switching from cigarettes to heat-not-burn is considered in the interests of public health, we believe it is possible that the tax burden may remain lighter than that of the combustible tobacco category. However, iQOS is a nicotine product, and therefore heatsticks are likely to be addictive. In this era of austerity, we think it is likely that governments will take a greater slice of the retail price than is currently being baked into the most bullish estimates, and we see that as a key risk to iQOS margins. It is also possible that if Imperial Brands IMBBY, British American BTI, and Japan Tobacco commercialize competitive products, the heat-not-burn category could move to a razor-and-blade model, with manufacturers absorbing the bulk of the cost of the kit in order to initiate consumers under their brand portfolio. This could be detrimental to the profitability of the business.

We think Philip Morris is a very strong business. Across the consumer staples group, consumers' tastes and shopping patterns are changing, bringing challenges to manufacturers in all categories. The tobacco industry appears well positioned to deal with these challenges, as does Philip Morris in particular, as its competitive advantages appear to us to be among the most robust in the space. However, the stock price has risen 30% over the past seven months and now appears slightly frothy, at a price/fair value estimate of almost 1.1. Therefore, we recommend that investors be opportunistic and wait for a margin of safety before building positions in this high-quality name.