Philip Morris Has Unrivaled Global Domination but Worrying Diversification

The power of branding can make or break a company. Luckily, as the owners of the world's eighth most-valuable brand, Marlboro, Philip Morris International (NYSE: PM  ) and Philip Morris USA, owned by Altria (NYSE: MO  ) , are unrivaled in terms of brand strength within the tobacco sector. Indeed, Marlboro is the only tobacco brand that makes it into the list of the world's top 100 most-valuable brands. It is this unrivaled brand strength that makes Altria and Philip Morris the most attractive tobacco companies in the sector. 

As the world's eighth most valuable brand, it is unlikely that Marlboro, and as a result Philip Morris and Altria, will disappear overnight. It is rare for a consumer goods company with such a rich heritage to die out, even though sales of Marlboro and cigarettes in general are declining slowly but surely. However, Philip Morris is not giving up.  

Branching out
In fact Philip Morris continues to expand, not in tobacco itself but in the distribution business. The company's most recent acquisition was a $750 million deal to acquire a 20% holding in Megapolis, Philip Morris' Russian distributor. This vertical integration should help increase efficiencies within Philip Morris, driving margins higher and increasing the company's reach .

That being said, while this expansion and integration is currently seen as a good thing for Philip Morris, it has not worked out so well for international peer Imperial Tobacco (NASDAQOTH: ITYBF  ) .

Peers struggling
Imperial Tobacco has been investing heavily in its distribution business during the last few decades, and now the company owns logistics operations around the world. These operations are run on an operationally neutral basis (no discrimination with competitors' products), and deliver tobacco products from all manufactures to more than 300,000 sales outlets. The company has also leveraged its distribution ability to a number of non-tobacco sectors, including pharmaceuticals. Imperial's most recent acquisition was a Cambodian distributor, which gave the company exposure to Asia. 

Although this move into distribution has allowed Imperial to diversify, profits from logistics are marginal compared to the tobacco side of the business. Indeed, according to Imperial's 2013 preliminary earnings release, the company's revenue for full-year 2013 was GBP 28.3 billion, or $46.1 billion. The company notes that net revenue from tobacco sales was only GBP 7 billion, or $11.4 billion. This indicates that out of Imperial's total revenue of $46.1 billion, $37.4 billion was related to the company's logistical operations. Unfortunately, Imperial only reported an adjusted operating profit from logistics of $287 million, which is an operating profit margin of only 0.77%--almost non-existent.

This tiny profit figure makes me wonder if Imperial would have been better off if it reinvested its cash elsewhere, rather than acquiring distribution operations.  Additionally, I'm concerned that Philip Morris could be heading in the same direction.

Wider margins
While Philip Morris International and Imperial Tobacco are diversifying into low margin distribution businesses, Altria has diversified into a higher margin business.

Altria is, in my opinion, one of the best tobacco companies that you can invest in. Why? Well, Altria is potentially the most diversified tobacco company in the world, apart from Japan Tobacco. While Imperial and Philip Morris have been building up their distribution networks and vertically integrating their businesses, Altria has been expanding into other markets, notably wine and beer.

For example, Altria's near 30% share in global brewer SABMiller and the company's Ste. Michelle wine holding reduces the company's reliance on the tobacco sector and provides wider profit margins than would be achieved in the logistical side of the business. In particular, while Imperial reported a profit margin of less than 1% for its logistics operations for full-year 2013, Altria reported an operating margin of just under 20% for its wine division for the three months ending Sept. 30. 

Foolish summary
Marlboro is one of the most valuable consumer goods brands in the world, and because of this I feel that Philip Morris and Altria are two of the best tobacco companies on the market. On the other hand, Philip Morris' diversification into the low-margin distribution business does concern me. Specifically, when looking at the tiny profit margin that Imperial has achieved from its distribution business, I'm left wondering if Philip Morris would be better off investing its cash elsewhere.

Still, Altria's ownership of the Marlboro brand within the US and the company's diversification into high margin products such as wine give me a good feeling about the company's future.

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