Many investors would never consider owning a tobacco company like Philip Morris International (PM -2.96%) or Altria Group (MO 1.45%) Tobacco use causes millions of deaths every year. This is the primary reason Warren Buffett refuses to buy a tobacco company, despite acknowledging the companies' enormous profitability.
Investors who have no qualms about owning such a company should take a close look at Philip Morris. The stock trades at a low valuation and -- for better or worse -- the company is thriving. For investors whose primary concern is compounding money at a high rate over time, Philip Morris is worth a closer look.
Best tobacco stock to own
Pre-split Altria was, by far, the best tobacco company in the world. It owned Marlboro, the best-selling cigarette on the planet, and had unmatched global breadth. After spinning off Philip Morris' international operations, Altria is now concentrated in the heavily regulated U.S. market. Although Marlboro is still the No. 1 cigarette in the U.S., smoking rates are quickly declining, and regulations tend to be tighter in developed countries. This is why Philip Morris International, which has operations in more than 180 markets and owns seven of the top 15 international cigarette brands, is a safer long-term investment than its old parent company.
Philip Morris' strong brands give it tremendous pricing power. Before subtracting excise taxes, Philip Morris generated a whopping 87% gross margin in 2012. This is a testament to the company's incredible product economics. Its premium brands, like Marlboro and Parliament, allow it to charge high prices in markets around the world.
However, Philip Morris' presence in high-tax countries in Western Europe means it brings in less money per dollar of sales than Altria. Philip Morris derives close to 30% of its revenue from the European Union, where excise taxes often make up more than 60% of the price of a cigarette. The average U.S. tax, however, is only 40% of the price of a cigarette. This is why excise taxes make up about 30% of Altria's revenue and it earns a 38% gross margin, while excise taxes make up 60% of Philip Morris' revenue and it earns a 27% gross margin.
Source: SEC Filings.
Philip Morris' heavy exposure to the European Union is probably why it trades at such a low price today. A little more than 600 billion cigarettes were purchased in the European Union in 2010, about 25% less than the nearly 800 billion purchased in 2000. The trend is not going to reverse; regulations in the region are only becoming more strict.
However, Philip Morris has a few things going for it. First, it entered into an agreement to copy and distribute Altria's e-cigarette technology outside the United States. E-cigarettes are gaining in popularity in developed nations as smoking restrictions and high taxation discourage cigarette use; the European Union -- Philip Morris' toughest market -- recently passed e-cigarette regulations that were less stringent than anticipated. This provides a source of growth in a market that is becoming increasingly hostile to tobacco companies.
Philip Morris also has growth opportunities in developing nations, where taxes are much lower than in the European Union. For instance, most parts of Asia, Africa, and South America have lower excise taxes than the United States. Moreover, the company is developing reduced-risk products that may eventually surpass sales of traditional cigarettes in developed nations. If all goes according to plan, Philip Morris will be able to offset volume declines in developed nations with reduced-risk products in developed nations and higher traditional cigarette sales in developing nations.
Priced for decline
Philip Morris consistently turns about 11% of revenue into free cash flow. Over the last four quarters, the company generated nearly $80 billion in sales. If it never grows revenue and continues to turn 11% of revenue into free cash flow, the company will generate $8.8 billion in free cash flow each year.
The stock's market capitalization is about $130 billion, so it trades at a 6.8% free cash flow yield ($8.8 billion divided by $130 billion). Philip Morris uses most of its free cash flow to pay dividends and repurchase stock -- so most of the free cash flow it generates goes right back to shareholders. If Philip Morris can continue to generate its current level of free cash flow, investors would get an outstanding return from a large and stable company.
If you believe that Philip Morris' revenue will continue to increase -- or at least hold steady -- and its profit margin will stay the same, then the stock represents an above-average investment for diversified portfolios.
Bottom line
The thesis is simple: If Philip Morris can maintain its current level of cash generation, shareholders will earn a solid return in a market in which few good returns exist. Investors just need to decide whether the company's unmatched brand portfolio will hold up long enough for reduced-risk products to gain widespread acceptance. If so, Philip Morris could be a winner.
