A Tale of 2 Tobacco Giants

Since the 2008 split of Philip Morris into Altria Group  (NYSE: MO  ) and Philip Morris International  (NYSE: PM  ) , these companies have had different challenges to face. If you were to choose one of these companies to invest in, which one would it be? To that end, let's consider these companies' revenues, risks, profitability, dividend, and valuation. 

Revenues and risks
Altria has a stronghold on the U.S market; this could also benefit the company in expanding its reach to other tobacco/cigarette-related products such as e-cigarettes and non-smoking tobacco -- two segments that are likely to slowly improve Altria's sales. But the company's high market share in its main business -- smoke products -- also allows little room for growth. Conversely, Philip Morris International expanded into emerging markets, which allowed it to increase its net sales by 3.4% in the first nine months of 2013.

In comparison, Altria's revenue remained flat during that time frame. Philip Morris International's rise in revenue was offset by strong competition from companies such as British American Tobacco and by unfavorable currency fluctuations. These are also among the main risks the company faces. 

On a yearly scale, Philip Morris expects to increase its diluted earnings per share to an average of $5.37 -- roughly a 4% gain. Besides the company's organic growth, it could also improve its performance by acquiring other companies; e.g., in early December, it announced a plan to purchase a 20% interest in Russian Megapolis Group. 

Conversely, Altria might not see much growth in sales anytime soon. Based on its third-quarter earnings report, the company is expecting to have a slightly better year in terms of diluted EPS, but this rise won't come from organic growth. The moderate gain will come from a win it recently had in arbitration for a reduced future payment toward the tobacco master-settlement agreement. But the legal issues are likely to keep Altria's uncertainty high -- currently the company has 90 cases open. 

Even the e-cigarette, which is slowly expanding its market share in the U.S, won't have much of an impact on Altria's revenue in the near future. Up to now, Altria has only rolled out its e-cigarette brand in several areas in the U.S. 

Lorillard continues to lead this market with its e-cigarette brand -- it has a market share of 49%. Despite its dominance in this market, the company's e-cigarette business had a very low profit margin of around 5% during the first three quarters of 2013. In comparison, cigarettes have a margin of around 30%. So even if Altria augments its market share in the e-cigarette business, it is likely to have little impact on its net profit or EPS. 

So Philip Morris has a better chance to slightly increase its sales compared to Altria. But how does this affect its profit margin? 

Profitability
The chart below presents the profitability of Altria and Philip Morris in the past several quarters. 

Source of data: Google Finance.

As you can see, Altria continues to maintain a much higher profit margin than Philip Morris. Moreover, in the first three quarters of 2013, Altria's profitability rose to 34% compared to 25% in the same time frame back in 2012. But Philip Morris' profitability declined from 18.4% in 2012 to 17.3% in 2013. Therefore, even though Philip Morris' revenue rose in 2013, the company's operating profit declined. Altria's wider profit margin is also reflected in its higher dividend yield. 

Dividend and stock-repurchase program
Altria's dividend policy is based on a payout ratio of 80%; i.e., the company's dividend payment per share is 80% of its diluted earnings per share. Under this dividend policy, the company provides an annual yield of roughly 5.1%. In comparison, Philip Morris offers a slightly lower dividend yield of 4.4%, which is around a 65% payout ratio. Besides a high yield, Altria decided back in August to raise its stock-repurchase program from $300 million to $1 billion. This decision implies the company's management believes Altria's stock still has room to grow. This could have also been among the contributing factors to the company's rally in the past year.

Philip Morris also has a share-repurchase program of $18 billion worth of shares over three years, dating back to August 2012. Therefore, both companies believe their shares are a bargain and offer high dividend yields. But is their price right? 

Valuation
In order to better understand the current value of these two giant tobacco companies, let's examine the ratio of their enterprise value to earnings before interest, taxes, depreciation, and amortization. I have used this metric due to the different financial structure of these companies including their debt and cash on hand; i.e., Altria's debt-to-asset ratio is 0.4, while Philip Morris International has a deficit in its equity and its debt-to-asset ratio is 0.7. Thus, Altria is in a better position in terms of debt than Philip Morris is. These companies' different levels of debt is partly considered in this metric. 

The table below presents the enterprise value-to-EBITDA of the above-mentioned tobacco companies and the tobacco market average. 

Source of Data: Yahoo! Finance and Damodaran's site.

As you can see, despite the sharp rise in Altria's stock price in the past year, its EV-to-EBITDA ratio is very close to Philip Morris'. Furthermore, both companies' ratios are higher than the industry average. These numbers suggest Altria's valuation is in line with Philip Morris'. 

Bottom line
Both companies have theire own relative advantages, and they both have similar valuations. But I think, based on the parameters listed above, Altria has the upper hand in terms of uncertainty, profitability, and dividend yield. These factors might be enough to put Altria ahead of Philip Morris as an investment worth owning.

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