ALEXANDRIA, VA (Jan. 12, 1998) -- Our first finalist in the Great Branded Food Company round up is Philip Morris (NYSE: MO), possibly the most controversial potential investment as well. Setting aside the real and perceived moral issues regarding such an investment for the moment, I first want to analytically look at the actual prospects for both tobacco and food businesses beyond the meager template we produced on December 31st.
Why are we considering Philip Morris from an investment perspective? Simply put, the company is a cash-generating machine. Returns at Philip Morris in all of its businesses are nothing short of impressive. Over the past twelve months, even though tobacco operations began to slow in the third quarter, return on average shareholder's equity was 29.2% compared to an average of 17.6% for the twenty food companies we have surveyed. Return on equity gives an investor a sense of what kind of money is being generated for each net dollar that is employed by the company. In the case of Philip Morris, for every dollar of assets it has in excess of liabilities, it brings in $1.292 in earnings.
Another metric to look at is the return on invested capital. This is a measure of how much in earnings is generated for every dollar of capital that is actually invested in the business. This differs from return on equity in that increasing debt will not change return on invested capital, although it will increase return on shareholder's equity. (As shareholder's equity is the difference between assets and liabilities, any increase in liabilities decreases shareholder's equity and increases return on equity.) Return on invested capital at Philip Morris is 31.6%, meaning that for each $1 invested in the business $1.316 is generated. The average for all the companies we looked at is 23.5%.
These high returns come from more than just the tobacco operations. With food and beer making up 44% of Philip Morris revenues last quarter, we can estimate that over the past year the company has generated $31.5 billion in food and beer revenues. ConAgra, which bills itself as the biggest "food" company in North America, is number two with $24.0 billion in revenues. Despite the attention focused on the tobacco operations at Philip Morris, the company is also probably the dominant branded, packaged foods purveyor in North America -- and quite possibly the world.
When the smoke finally clears from the tobacco legislation and the perceived risk premium is removed from the valuation, it would not be unreasonable to see these food operations by themselves trade at the 2.5 to 3.5 times sales that other successful food companies warrant. At 3.0 times sales, the food and beverage operations alone would be worth $94.5 billion, 86% of its market capitalization and 78% of its enterprise value. This suggests that at current prices the core value from the food and beverage operations is $36 1/4 to $40. With Philip Morris generating returns that are in the top tier of all branded food companies, it is not unthinkable that in a post-tobacco settlement world, even with profits drained from settlement costs, the valuation multiple to sales might actually increase.
Without the risk from the tobacco operations, it would be indisputable that Philip Morris is undervalued. The 3.4% yield the company pays is more than two times the 1.62% the average company on the S&P 500 currently pays. In addition to this, the company paid 27% above the dividends shareholders received to repurchase shares, making the effective owner's yield more like 4.3%. Even with earnings growth apparently decelerating in the tobacco operations, investors are looking for 13% earnings growth from 1997 to 1998. The company trades at 16.4 times trailing earnings, compared to an average of 27.2 for the other twenty food companies we are examining. Even more compelling is the fact that the company trades at 14.0 times '98 earnings estimates, in line with the rate of earnings growth. On finances alone, Philip Morris represents a compelling investment.
Based on this and the increasingly likelihood of a tobacco settlement, prospects for Philip Morris are interesting. Florida, Mississippi, and Texas have already settled independently, putting the pressure on Congress to deliver an omnibus settlement. Although they are only three states, they represent 13.7% of the population in the United States. Given that these state settlements average $780,000 per person versus the $1.4 million the current national settlement would pay, the deal offered to Congress as a whole is better than what the states are eking out on their own. If this doesn't put pressure on Congress to move, the fact that today President Clinton included tobacco settlement money in a budget proposal pushes the issue even farther.
On a purely cash basis, if Philip Morris gets protection from future class action lawsuits, the current settlement is a good one. The way it is structured would have the same amount paid each year. Relative to the growth of the company, the static settlement would gradually become less and less important within the company's overall results, meaning that although there might be short-term financial heartache and a flat share price over a long period of time, the increased multiple at which the litigation-free earnings will be valued will quickly overcome any settlement-inspired decrease.
Before launching into the pros and cons on the perceived moral side of the investment, instead I would like to again table that discussion until looking more closely at the other four finalists. As the settlement will reduce near-term earnings per share at Philip Morris by somewhere between $1.50 to $2.50 per year depending on the company's current tobacco market share, the company will certainly be able to pay its dividend and minor capital expenditures, but could end up having flat returns for a number of years. If one of our other three contestants looks interesting, despite the apparent financial perfection of Philip Morris, there might be a darn good financial reason to invest in something else.