Market Overreacts to Philip Morris, Shares Attractive
A first-quarter volume miss in Heatsticks doesn't dim the prospects of the wide-moat firm.
Our long-standing thesis on wide-moat Philip Morris (PM) is that iQOS, the company's market-leading heated tobacco technology, has the potential to prolong the lifespan of the tobacco industry, but that the adoption rate of the category will plateau, and that the effervescent growth expectations being priced into the stock are too optimistic. A first-quarter volume miss suggests that plateau has now been reached. The market's reaction appears extreme (the stock fell by 15% in the aftermath of the call), suggesting that the heated tobacco category is still misunderstood. Nevertheless, we are lowering our forecasts for Heatsticks growth and margins in Asia, although the impact of these changes on our valuation is offset by the weaker U.S. dollar and by a lower effective tax rate, and we are maintaining our $104 fair value estimate.
Two issues stand out from PMI's first-quarter results. First, the company missed volume expectations, reporting a total tobacco volume decline of 2.3%, versus consensus estimates of flat in the quarter and our full-year assumption of a decline of 1.3%. With combustibles in line with expectations, the miss was caused by a significant shortfall in Heatsticks shipments in Japan, which we believe was driven by a pullback in shipments in order to rightsize channel inventory.
Second, a boost from a lower effective tax rate, now being guided to 26%, down from 28%, is not filtering down to earnings in full. We assume 26% to be the ongoing tax rate, but that the customer acquisition cost in the emerging tobacco categories may be higher than originally thought. We have lowered our medium-term margin forecast by around 90 basis points to account for heavier investment behind customer acquisition, and we have increased our estimate of PMI's investment rate in stage II of our model to 14%, to be more consistent with companies in more competitive consumer staples categories.
Morningstar Premium Members gain exclusive access to our full analyst reports, including fair value estimates, bull and bear breakdowns, and risk analyses. Not a Premium Member? Get this and other reports immediately when you try Morningstar Premium free for 14 days.
Philip Gorham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.