Philip Morris (PM 0.78%) is bucking a trend by making big investments in new products. Tobacco companies have returned gobs of free cash flow to shareholders over the last few decades as the combustible cigarette market continues its decline in developed nations. However, Philip Morris is now investing billions to research and develop a new suite of reduced-risk products. Here's a look at how much the company is spending and what it expects to get from the investments.
A new platform
Philip Morris has invested approximately $2 billion to research and develop new products that could become less-harmful cigarette substitutes. The company has four different reduced-risk products, or RRPs, in its pipeline. Two of the products -- called Platform 1 and Platform 2 -- heat tobacco rather than burn it. The other two -- Platform 3 and Platform 4 -- are battery-powered e-cigarette devices that deliver nicotine via an aerosol.
Philip Morris' RRP pipeline could revolutionize nicotine delivery. Source: Company presentation
While Platforms 3 and 4 are similar to other e-cigarettes, Platforms 1 and 2 are unique products that other tobacco companies do not offer. The holy grail of the tobacco industry is to develop a product that looks and feels like a cigarette, but is actually less harmful. The heat-not-burn technology in Platforms 1 and 2 is designed to give users the same tobacco taste and nicotine load as combustible cigarettes, but there may be fewer harmful chemicals released since the tobacco is not burned.
So far, Philip Morris' RRP investments have included building two research and development centers, hiring over 300 scientists, and conducting numerous clinical trials. Platforms 1 and 4 are scheduled for release in test markets in the fourth quarter, while the other two platforms are not expected to hit the market until 2016.
Are products worth the cost?
There is an opportunity cost associated with any spending the company does; the company could instead return the cash to shareholders through dividends or share repurchases. Philip Morris plans to spend $1.2 billion in capital expenditures during 2014, most of which is focused on bringing the RRPs to market. Many of Philip Morris' shareholders own the stock because of its large quarterly dividend, so the company needs to have a really good reason for investing cash in what many consider to be a dying industry.
Fortunately, Philip Morris' RRP investments may be worth it in the end. Management projects RRPs to generate $720 million to $1.2 billion in annual profits once the products reach scale. A $1 billion increase would grow Philip Morris' operating profit by 7.4%. Moreover, Platforms 1 and 2 will give the company a differentiated offering from competitors' e-vapor products that are already on the market. This could give the company a head start in a new product category should smokers prefer the heat-not-burn technology to e-vapor technology.
Most importantly, Philip Morris is making significant investments in future growth while still returning most of its cash flow to shareholders. In 2013, Philip Morris returned $11.7 billion to shareholders through dividends and share repurchases, compared to just $1.2 billion in capital expenditures. Given the company's track record for prioritizing dividends and stock buybacks, investors can expect the pattern to continue. This lowers the risk that RRPs cause a drag on shareholder returns because, even if the products never generate a profit, only a relatively small portion of cash flow is being used to fund the development. As a result, the RRP investments are likely a good bet for shareholders.
Takeaway
Philip Morris has committed to investing a modest level of cash flow in products that could revolutionize the way smokers get their nicotine. If the company's RRPs achieve management's profit goals, shareholders will reap the upside. If the products do not do as well as planned, the stock's 4.7% dividend yield offers downside protection. As a result, Philip Morris' capital spending plan is likely a good one for shareholders.
