In investing, perspective is everything. The entire reason the stock market exists is because we have a wide swath of opinions as to where it, and the thousands of components that comprise the major indexes, will head next. Some of those opinions will be right, and others will be wrong, but everyone has their reasoning and justification for feeling the way they do about the broader market, or about individual stocks.
Generally speaking, I tend to take a more skeptical approach to investing. While I wouldn't go so far as to call myself a bear, I do tend to be considerably more critical of the broader market and of the valuations of leading companies than the average investor.
Still, every once in a while, I find myself on the other side of the fence. Recently, that's what happened with brand-name discretionary goods company Philip Morris International (NYSE:PM). Despite its taking a tongue-lashing from Wall Street and a short-term beating from investors following its latest quarterly operating results, from my perspective, it might be too cheap to pass up.
Three reasons Wall Street can't stand Philip Morris International
Let's begin by addressing Wall Street's thesis that tobacco company Philip Morris is a stock to avoid. There are three main reasons that investing professionals have this opinion.
First, tobacco sales are down, and they've been falling for quite some time. Developed countries have been waging war on the industry in an effort to improve consumers' health. Though you probably don't need the reminder, smoking tobacco has been linked with considerably higher risks of heart disease, cancer, and a host of other serious diseases and ailments. In Philip Morris' second-quarter results, it reported a drop in year-on-year cigarette shipment volume of 2.8 billion units, or 1.5%. This trend is expected to continue for the foreseeable future.
Secondly, we're witnessing the dawn of the legal cannabis industry in select countries. Certain U.S. and Canadian polls (Philip Morris doesn't operate in the U.S.), as well as analyst chatter, have shown the potential for consumers to trade away from alcohol and tobacco products and toward cannabis as a legal alternative. Recently, Imperial Brands became the first tobacco company to invest in the marijuana industry, but there's clear concern from Wall Street that the tobacco industry could see sales dwindle as a result of the legal marijuana movement.
Finally, sales at the company's heated-tobacco unit, iQOS, have been disappointing. During the first quarter, Philip Morris noted that sales of the product, which were being tested in Japan, appeared to have plateaued. Though that reasoning didn't prove accurate, weaker-than-expected uptake in the product has continued. Analysts at Trefis have suggested that more reliable and longer-lasting iQOS devices have led to fewer replacement purchases. They also believe older consumers (aged 50-plus) are a tougher crowd for Philip Morris to reach.
Ultimately, Philip Morris lowered its full-year guidance for earnings per share to a new range of $5.02 to $5.12 from its previous guidance of $5.25 to $5.40.
With tobacco sales ailing and the company's bet on a smoke-free future faltering, it's no surprise Wall Street simply wants to butt out.
Here's why I believe it's a bargain
But investing is all about perspective -- and this investor smells a bargain.
To begin with, tobacco stocks like Philip Morris bring incredible pricing power to the table. Nicotine is an addictive substance that makes quitting very difficult. As a result, the company usually has little trouble passing along higher costs to its consumers, who willingly pay those costs. Despite falling cigarette shipments, there's a very real possibility that Philip Morris can maintain or even grow revenue as a result of its exceptional pricing power.
Next, investors should understand the geographic scope of a company like Philip Morris. Whereas Wall Street has railed for years about Altria's ailing tobacco business, they forget that Altria is stuck dealing with an anti-tobacco U.S. market, while Philip Morris is operating in more than 180 countries around the world, of which the U.S. isn't one. Even as traditional tobacco sales are pressured in developed countries, expansion is possible in emerging-market regions like the Middle East, Southeast Asia, and Africa. Although cigarette shipment volumes are expected to decline, I don't believe the long-term picture for combustible tobacco is as grim as Wall Street has painted it, due to these emerging-market economies and the desire of their burgeoning middle classes for simple luxuries, such as access to tobacco products.
Let's also focus for a moment on the company's iQOS heated-tobacco device. Though there is modest concern that usage rates are slowing in Japan, there's still plenty to be excited about. This is a product that's only recently been launched in a number of developed markets. During the second quarter, the entirety of Philip Morris' international market-share expansion (roughly 0.8 basis points, to 28.4%) came from its HeatSticks, which are used with its iQOS device. The user base in Europe has jumped from 300,000 in Q2 2017 to 1.2 million in the most recent quarter, while regional market share in Europe rose from 0.2% to 1%. While these are small figures, they also show that iQOS usage is trending in the right direction.
Building on that point, and taking into account the concerns addressed by Trefis, it wouldn't be out of the question for Philip Morris to simply adjust its marketing strategy to better reach older combustible-tobacco users. Just because these users haven't jumped on board with heated tobacco products doesn't mean they're a lost cause. Marketing is a trial-and-error process, and if Philip Morris can find a way to reach this large share of its combustible market (the over-50 crowd), it could give its smoke-free line of products a sales jolt.
I also appreciate the various levers that management can pull to create value for the company's investors. After capital expenditures, dividends to shareholders are the primary use of its operating cash flow. In June, the company increased its annual payout by 6.5% to $4.56 a share, marking the 11th consecutive year of increasing its dividend. Its current yield of 5.5% is nearly triple the average annual yield of an S&P 500-listed company. Plus, should management choose, a share buyback program could be instituted that would reduce the number of shares outstanding, helping with EPS and the company's relative valuation.
In other words, things aren't nearly as dire as Wall Street has made them out to be over the long run. Meanwhile, the company's expansion of iQOS, coupled with its pricing power and its ability to rein in costs, should allow its adjusted EPS to expand by between 5% and 10% annually through 2021.
My thinking is that Wall Street has Philip Morris International all wrong, and it's squarely on my watch list as a possible stock worth buying.