Philip Morris: Future Prospects and Pressure From Headwinds

Since 2009, Philip Morris International (NYSE:PM) has managed to deliver modest increases in revenues (see Figure 1) predominantly driven by market share gains and pricing. Although we expect the company to continue maintaining its revenues, a number of headwinds could threaten prospects going forward, namely:  a fall in volumes, an increase in regulatory control, a rise in contraband, and a strong U.S. dollar. However, does this mean things will be downhill from here on for Philip Morris? Probably not, and here’s why:

Figure 1: Philip Morris Revenues, data from 10-K filings

1. Volume declines in key markets: Philip Morris’ biggest advantage lies in the fact that the company operates across diverse geographical regions. Apart from allowing them to hedge against risks associated with any particular market, it also gives them exposure to a number of developing markets that had actually been seeing increasing cigarette volumes. However, in the past two years, volumes in key Asian, African, and Latin American markets have been facing declines against excise increases and tighter regulation.

However, is this reason enough to worry? Probably not — Going forward, Philip Morris’ story could resemble its American counterpart Altria’s, where all the loss in volumes is compensated for by further price hikes. Most tobacco players are well aware that they are functioning in a declining industry and have instituted a number of ways to compensate for this, the most common being an increase in prices. This strategy actually works for these companies given the addictive properties of the product that they sell, which makes demand relatively price inelastic, i.e. demand is less sensitive to a change in price. ^[1] Furthermore, in spite of declining cigarette volumes, certain segments such as reduced-risk products and e-cigarettes have been gaining momentum recently. In this case, these segments could offset some of the decline in cigarettes going forward.

2. Regulatory crackdown on tobacco sales: Players in the tobacco industry could be confronted with certain benefits on the merit of the addictive property of cigarettes. One of this is a relatively acyclicality, or a slower response of cigarette sales to business cycle fluctuations. However, for this very property, the tobacco industry is often scrutinized by regulators and health advocates. For instance, many markets have recently seen policy changes in terms of advertising, smoking in public areas, and packaging. In this situation, Philip Morris’ success may be highly conditional on these policies since they could potentially hurt volumes.  Over the next few years, the European Union is set to introduce a number of new rules, which includes a 65% coverage of cigarette and roll-your-own tobacco packs with picture warnings, a ban on “lipstick-style” packs that target women smokers, flavor additives (including menthol), and the 10-cigarette packs. Furthermore, the EU will also install a maximum nicotine-concentration limit on e-cigarettes, a ban on promotional lines such as”this product is free of additives” or is “less harmful than other brands.” ^[2] These measures, when implemented, could have an impact on demand.

Having said this, however, companies like Philip Morris are used to this constant source of stress from regulatory authorities. Furthermore, in many cases policies such as plain packaging laws, or a ban on advertisements, could actually be good news for Philip Morris, since it could make it harder for smaller tobacco companies to build their customer base, leading them to eventually drop out of the market. Such laws could also deter new entrants, in which case, lesser competition could be an advantage for Philip Morris in terms of higher market share and stronger pricing power.

3. Increase in illegal sales: Going forward, Philip Morris could be hiking up prices — partly in response to excise hikes, and partly to mitigate losses from declining volumes against increasing anti-smoking regulation, and rising health awareness among consumers. However, as prices keep increasing so could the proliferation of contraband. According to the company, Marlboro is the “most heavily counterfeited international cigarette brand,” which along with “contraband, legal cross-border purchases, and non-tax-paid volume produced by local manufacturers” has resulted in sizeable revenue losses for Philip Morris. ^[3]

According to a recent report by KPMG, approximately 10.4% of all cigarettes consumed in Europe were illicit. ^[4] In Australia, the figure was stood at about 14%. ^[5] Furthermore, a report by International Tax and Investment Center and Oxford Economics in 2012 suggests that close to 9% of all cigarettes sold in Asia were illicit — with some five markets having a share of over 25%. ^[6]

However, illicit trade has been a factor that tobacco companies have been historically battling. While increasing illicit trade leads to reduced revenues for tobacco companies, it could ward off further excise increases. This is because, from a policy standpoint, a burgeoning illicit market will fail to actually reduce cigarette consumption, while hurting government finances in terms of higher costs to keep illicit tobacco under check, and lower excise income from the sale of tobacco in the legal market.

4. Strengthening U.S. Dollar: Lastly, there is the matter of the U.S. dollar. Philip Morris has been facing tougher circumstances as the U.S. dollar has strengthened tremendously against a number of key currencies. Since a majority of Philip Morris’ sales are conducted in local currencies, a stronger U.S. dollar implies fewer dollars in exchange for the local currency. The Dollar Currency Index, which measures the strength of the U.S. dollar against a number of other currencies, has continuously gained points over the past year, to hit its highest level in nine years. In Philip Morris’ case, a weaker Russian ruble, Japanese yen, Argentine peso, Ukraine hryvnia, and Indonesian Rupiah, resulted in lost revenues of approximately $2 billion in 2014.

U.S. Dollar Currency Index

Going into 2015, some analysts anticipate the dollar value to fall especially as the Federal Reserve acknowledges how a strong dollar is curtailing growth in the U.S. economy. However, others expect further strength as the U.S. economy continues to remain upbeat in comparison to a number of other countries. Furthermore, the anticipation of an interest rate hike could also increase dollar demand to set the currency hitting further highs. Against this, going into 2015, Philip Morris anticipates net earnings to be impacted by close to $1.7 billion adversely affecting free cash flows. If the dollar strengthens further, this figure could be even larger.

However, currency headwinds may not be reason enough to write off the stock since it could just be a short-term phenomenon. Although the stock has been harmed due to unfavorable exchange rate movements, fundamentals have not really changed much. For instance, on a currency neutral basis, adjusted diluted EPS witnessed a 7.8% growth in 2014 and is expected to undergo a 8-10% growth even in 2015. ^[7] Given that Philip Morris is not going wrong structurally, but has just fallen prey to dynamics in currency, there may be good news in store for the company as the dollar rate eases.

In conclusion, although Philip Morris has managed to sustain its revenues so far, it could have much to face both at the micro and macro levels. In spite of this, we believe that these may just be temporary headwinds, that the company could work around, to go on to deliver promising results in the longer term.

We have a price estimate for Philip Morris’ stock price of around $80, which is in line with the current market price.

See Our Complete Analysis For Philip Morris International

View Interactive Institutional Research (Powered by Trefis):

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap | More Trefis Research

1. Why is demand for cigarettes inelastic? [↩]
2. Packets of ten cigarettes and menthol flavours banned under new EU rules [↩]
3. Philip Morris 10-K, SEC [↩]
4. 56.6 Billion Illegal Cigarettes Consumed in the EU in 2014, Worth More Than €11bn in Lost Tax Revenue [↩]
5. 2014 KPMG Report: Illegal Tobacco at Record Levels in Australia [↩]
6. Asia 11 – Illicit Tobacco Indicator [↩]
7. Q4 2014 Earnings Call Transcript [↩]