What Is the Market Smoking?

We do not understand the market's negative reaction to the news that Philip Morris International PM and Altria MO are in talks regarding a potential all-stock merger of equals. The decline in the market value of PMI is particularly surprising, given the absence of a valuation premium. It has been our long-held view that this combination would occur, primarily to align the interests of both parties in the distribution of iQOS in the United States, but also because of the potential for cost synergies, the ability to manage the world's largest cigarette, heated tobacco, and vaping brands under one roof, and for PMI, the natural foreign-exchange hedge that U.S. distribution will bring. We reiterate our fair value estimates for both companies and think the sell-off creates an attractive entry point to an already undervalued group.

The combination of PMI and Altria would be a reversal of the decision to separate 11 years ago. In some ways, that strategy has become redundant: The class-action litigation risk that Altria was trying to isolate within the U.S. entity has eased, while value was arguably not created by separating the international business. PMI traded at around 15 times forward earnings before this announcement, and Altria at 11 times--the same multiples they were valued at after the split in 2008. In the 11 years since, however, the market has changed significantly. The advent of cigarette substitutes has driven the decline rate of cigarette volume higher, from around 3% a decade ago to 5% now, and prompted a race among manufacturers to build portfolios of new products across multiple categories. Regulatory risk has grown, with more-assertive regulators clamping down on marketing in both cigarettes and emerging categories. Higher risk and accelerating volume declines may explain investors' negative reaction to the talks.

In our view, however, this overlooks a number of key benefits of the deal. First, this merger would align the interests of the two parties around iQOS, PMI's heated tobacco product. Altria plans to test-market iQOS in Atlanta next month under license from PMI and is likely to roll the product out in the U.S. more broadly next year. However, assuming Heatsticks (the heated tobacco units compatible with the iQOS device) are priced comparably with cigarettes, and assuming similar tax structures, it is difficult to see how cannibalization will be anything but dilutive to Altria's profitability. Altria will pay an undisclosed royalty to PMI on iQOS sales in the U.S., Heatsticks are likely to lack the economies of scale of cigarettes for many years, and we estimate margins on the devices to be around 10% at the full retail price and break-even at discounted prices. Therefore, we believe that under the existing corporate structure, Altria is not financially motivated to migrate its volume from Marlboro to iQOS, and that this is incompatible with PMI's strategy of investing heavily in the development of heated tobacco. We believe a strong launch of iQOS in the U.S. would be a catalyst for PMI's stock next year, so PMI's management is motivated to make it a success.

Scale is important in cigarette manufacturing (there is an historical inverse correlation between scale and average cost of sales), and large manufacturers have a cost advantage over smaller ones. Nevertheless, we regard cost synergies to be an added bonus rather than a key driver of this deal. We estimate that the elimination of duplicate back-office functions could save the combined entity around $200 million annually, or 2% of combined entity operating costs last year. Total cost savings are likely to go much higher, however, as there will be scale advantages in tobacco leaf procurement and if PMI imposes its zero-based budgeting strategy upon the U.S. operations. The cost opportunity will depend on which management team ultimately controls the business. We expect PMI management to dominate, given PMI's relatively larger valuation (at the announcement's market values, PMI shareholders would own around 58% of the new combination and Altria shareholders 42%) and its experience both in heated tobacco and internationally.

The obvious internal use of the incremental cash flow from cost synergies would be to fund the growth of Juul outside the U.S. It is not clear at this stage, however, whether noncompete clauses in Altria's ownership agreement with Juul will prevent PMI from distributing the vaping device internationally. If that is not the case, the opportunity to take Juul global would appear to be another rationale for the deal, although the jury remains out on whether the economics of vaping will replicate those of cigarettes. Similarly, Altria's exclusivity agreement may also prevent the combined company from distributing iQOS Mesh, PMI's vaping device, and its other products acquired from Nicocig in 2014. We ascribe no value to those opportunities until visibility is provided on the distribution limitations of the Altria-Juul deal.

We expect the deal to close, but the negative reaction of the market may indicate that shareholder approval should not be taken for granted. In the long term, it is not inconceivable that the structure of this business will involve another breakup, but next time on product lines: one business focused on combustible products globally, delivering high margins and strong cash flow generation, and the other business focused on developing and marketing next-generation products that yield higher growth rates but require heavier investment. We expect this to happen in a few years when next-generation products are profitable and cash flow generative. Until then, we think this deal makes a lot of sense, particularly for PMI.