The Boring Portfolio, Mar. 8, 1999

<THE BORING PORTFOLIO>
Checking out Philip Morris
Looks cheap!

By Dale Wettlaufer ([email protected])

ALEXANDRIA, VA (March 8, 1999) -- I was in Richmond this weekend and I also flew over the Virginia capital this morning on the way back from Charlotte. My thoughts turned on both occasions to Philip Morris (NYSE: MO), which is headquartered in that city.

The Bore port has excess capital lying around earning a money market rate of return, which is far below our hurdle rate of 125-136% the historical yearly rate of return on equities. So we obviously need to do something to make hitting that bogey easier. We don't necessarily have any thoughts about the market going down tomorrow or next week. I will say there's lot of over-priced junk and over-priced good companies out there, but I will also reiterate that there's always value as well. We don't time markets. We just look for companies that can get us to the rate of return we expect out of our investment universe.

So, Philip Morris. You might love it and you might hate it. I know some people believe our considering an investment in the company is a political act in and of itself, but I would not want to spend every day over the next five years debating that question. All I can say is that we can't please everyone. Earlier this year, I wrote about the company for our "Dueling Fools" feature. While I don't do this feature often, I believe the secret is to do what are obvious layups. Berkshire Hathaway (NYSE: BRK.A), Charles Schwab (NYSE: SCH), and Philip Morris are three that I considered to be lay-ups when I did them. With Philip Morris back at the same price as it was earlier this year, we might want to think about stepping up to the plate.

Here's what we have: 1998 after-tax operating earnings of $9.43 billion -- before charges for the tobacco settlement and some early retirement benefits -- on $57.813 billion in net revenues. That's on average invested capital of approximately $42.21 billion, which is about what you expect for a franchise consumer products company -- slower turnover of capital and larger margins. A 22% return on capital, 16.3% net margins, and 1.37 capital turns is pretty much down the middle for this kind of company. Still, though, if you know Coca-Cola Co. (NYSE: KO), you know why it's such a great moneymaker. Coke has even better margins and capital turns, though some people have a problem with the way the company's accounting is presented.

In any case, we have $97.8 billion in equity value and $14.66 billion in debt. I won't count in any excess cash, so we have an enterprise value of about $112.5 billion -- about 12 times net operating profit after tax. That's cheap anyway you look at it.

Earlier this year, I broke down the 1997 results like this:

With 1997 after-tax operating earnings of $2.66 billion (my estimate, adding back goodwill expense attributable to the food business and using a tax rate of 33% to account for extensive international operations), the food business alone should be priced between 28 and 32 times earnings. That's $74.36 billion to $84.9 billion.

Philip Morris's beer business (Miller) generated operating earnings of $456 million last year. At a 36% tax rate, after-tax operating earnings would be $291.8 million. I would pay between 18-20 times earnings for this business, putting my valuation on Miller at $5.25 billion to $5.84 billion.

Finally, Philip Morris has some finance operations hanging around. With a 1997 return on assets (ROA) of 2.1% (I've backed out a gain of $103 million that the company took), the company generated $121.6 million in earnings before extraordinary items. With a value of 16 times earnings or 35% of assets, the valuation on the finance unit falls right around $2.06 billion.

Adding up all non-tobacco businesses, we get a range of $81.7 billion to $92.8 billion. Taking away from the net debt that I would think is reasonably attributable to these businesses (60% of the consolidated company's net debt), we get an equity value of $72.9 billion to $84 billion. On 2.446 billion shares, that's $29.80 to $34.34 per share.

At the recent quote of $39 3/8 per share for the overall company, the tobacco company is being valued at $5.03 to $9.58 per share, net of debt.

Let's see. We've got the tobacco company earning after-tax operating income (plus goodwill amortization) of $5.392 billion. That business is incredibly rich in free cash flow and generates incredibly high returns on invested capital (ROIC), perhaps in the 50% range. As we know, ROIC should play as large a part in valuation as earnings growth does, because a high-ROIC business has the luxury of returning lots of capital to owners at the same time that it's able to finance internally its growth needs. So, to value this segment of Philip Morris, we need to first consider what its value is if the threat of increased government regulation did not exist. Then we'll discount the regulatory threat.

To be honest, I think the tobacco operations are worth more, but to be conservative, I'll go to 30-35 times after-tax operating profit as a reasonable valuation for the tobacco business. That gets us total value of $161.8 billion to $188.7 billion for the tobacco operations. Less net debt of $5.864 billion, that's $63.75 to $74.75 per share that we add to the above. So, before all the hassles that the company and industry currently face, Philip Morris is worth $93.55 to $109 per share. If the market is efficient, it is pricing the net present value of the legal liabilities at about $53 to $69 per share, or $129 billion to $169 billion. I personally don't see where that's reasonable. Quantifying the legal liabilities further and building a better model of Philip Morris will occupy some of my time in the near future. It looks pretty darned cheap, however, even with the problems it faces.

Everything was steady as she goes in the Portfolio today. Same companies we left in the Portfolio on Friday. One bit of news: American Bankers Insurance (NYSE: ABI) has agreed to be acquired by Fortis for $55 per share in cash. That would have been a short-term relationship for the Boring port and we're not into the tawdry flings.

Have a good Monday night. We hope to see you on the Boring message board soon.

• Discuss Boring Investing on the Boring Port message board.
• 10/01/98: The New Boring Port Transitions Facts

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Stock  Change    Bid
BRKb  +24      2437.00
CSL   -  5/16  42.06
CSCO  +3 3/4   104.56
GTW   +2 7/16  71.38

                   Day    Month   Year  History
        BORING   +1.87%   3.10%  -1.35%  32.46%
        S&P:     +0.57%   3.59%   4.67% 113.70%
        NASDAQ:  +2.59%   4.79%   9.35% 130.33%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96    104.56   336.49%
  8/13/96  200 Carlisle C    26.32     42.06    59.78%
 12/31/98    8 Berkshire   2244.00   2437.00     8.60%
   2/9/99  100 Gateway 20    72.38     71.38    -1.38%


    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  23526.56 $18136.57
  8/13/96  200 Carlisle C  5264.99   8412.50  $3147.51
 12/31/98    8 Berkshire  17952.00  19496.00  $1544.00
   2/9/99  100 Gateway 20  7237.50   7137.50  -$100.00


                             CASH   $7658.52
                            TOTAL  $66231.08