Philip Morris' Final Frontier: What It Means for Shareholders

Philip Morris International has a huge growth opportunity in Asia that is not available to Altria Group.

Feb 16, 2014 at 8:00AM

Cigarettes are coming under fire from all directions. From wise individuals who avoid or quit the smoking habit to zealous civil servants intent on eliminating tobacco use altogether, there are enough people actively fighting the tobacco industry to create a difficult operating environment for the companies.

However, unlike Altria Group, which must content itself with a shrinking U.S. cigarette market, Philip Morris International (NYSE:PM) is one of the few major tobacco companies that still has growth opportunities. In fact, Philip Morris' growth opportunity in Asia is such that the stock's price-to-earnings ratio of 15 times seems low, even for a mature company in a declining industry.

Asia: The final frontier
Philip Morris invested more than $1 billion last quarter to expand in Mexico and Algeria -- both of which offer decent growth prospects. However, it is Asia that offers the longest runway for growth.

Asia has quickly become Philip Morris' most important market. It generates nearly 37% of the company's operating profit -- accounting for a greater percentage of Philip Morris' profits than any other segment. In 2008, Asia generated less than 20% of the company's overall operating profit, well behind Europe and the Middle East in terms of importance to the company.

Asia's rising importance to the tobacco industry is no fluke. The weak economic conditions, high excise taxes, and harsh marketing restrictions that make Europe a difficult operating environment are not present in much of Asia. In addition, booming population growth is adding millions of potential Asian smokers each year. As a result, Philip Morris has an enormous opportunity to expand in the region.

Indonesia and the Philippines
Indonesia represents Philip Morris' easiest growth market. A whopping two-thirds of Indonesian males smoke tobacco. The high smoking rate is probably due to the country's lax tobacco marketing laws; a 2012 survey discovered that more than 80% of Indonesians had seen cigarette advertisements within the last month, a far higher rate than any other country surveyed. One of the reasons the European market is declining is that Philip Morris is unable to blast advertisements out to potential consumers and grow its market share. Indonesia, on the other hand, is a prime market for one of the world's largest nongovernmental tobacco companies to use its vast cash flow to flood consumers with persuasive advertising.

Moreover, Indonesia's strong economic growth -- GDP is increasing at more than 6% per year -- and rising middle class and affluent consumers -- the group is expected to double from 74 million in 2012 to 141 million in 2020 -- presents an opportunity for Philip Morris' premium brands to grow as the nation accumulates greater wealth.

The Philippines also represents an opportunity for Philip Morris to grow its share, but the government is far less lenient than Indonesia. The Philippines hiked its excise tax in January 2013, sending Philip Morris' sales volume into a free-fall; lower shipments in the Philippines represented nearly half of the decline in Philip Morris' cigarette volume -- a huge dropoff for one region.

However, investors should remain optimistic about the region's prospects. Management believes that after a government crackdown on tax evaders, Philip Morris will dominate the market as the price difference between discount brands and premium brands is reduced. Given that 48% of adult males in the country smoke tobacco, there will be pressure on the government to maintain access to tobacco products -- ensuring Philip Morris' continued presence in the country.

Wild card: China
China is a potentially game-changing growth opportunity for Philip Morris. Chinese consumers smoke 2.5 trillion cigarettes each year -- that's 40% of the world's total cigarette consumption. Moreover, China's cigarette consumption is expected to rise 14% per year through 2015; investors would be hard-pressed to find a faster-growing market.

However, Philip Morris participates in the market only indirectly through a partnership with state-owned monopoly China National Tobacco Company, or CNTC. CNTC is a huge source of revenue for the Chinese government -- generating as much as 10% of government tax revenue -- making it unlikely that the country will allow foreign tobacco companies to enter the market.

CNTC distributes Marlboro cigarettes in China through a licensing deal with Philip Morris, but Marlboro's share is a paltry 0.3% of the Chinese market. Philip Morris is trying to ingratiate itself with Chinese authorities by introducing less harmful products in the Chinese market. For instance, the company is working on developing a flu vaccine that is derived from a tobacco plant. It is also trying to boost its presence through reduced-risk products -- still under development -- that are less harmful than cigarettes. Any headway into the Chinese market would be a huge plus for Philip Morris' growth.

Foolish takeaway
Philip Morris is not about to turn into a growth stock, but it has the potential to significantly grow its revenue through Asian expansion. Indonesia represents the clearest path to growth, while the Philippines will eventually stabilize and provide a path toward greater market share. Those two countries should drive significant revenue gains for the company over the next five years, but expanded entry into China could be a game changer.

In any case, it is clear that shareholder value is becoming more concentrated in the relatively pro-smoking East rather than the anti-smoking West -- a huge benefit for Philip Morris shareholders.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool owns shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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