Philip Morris (PM 1.17%) has been among the worst-performing tobacco companies this year, with shares up only 2% year to date. Just over the past week, the tobacco giant lost more than 7% of its market cap in light of a pessimistic earnings forecast for the next quarter. In comparison, competitors Reynolds American (RAI) -- which owns the popular brand American Spirit -- and Lorillard Tobacco Company (LO.DL) -- owner of menthol-flavored cigarette brand Newport -- are up 22% and 32%, respectively, year to date.
Although Philip Morris has been able to sustain robust pricing for many years, a challenging macroeconomic environment, together with increasing competition, could be behind the recent guidance revision. Furthermore, with roughly 29% of the global market share of tobacco in its pocket, the company may find it very challenging to keep growing its top line.
However, as Morningstar analyst Thomas Mullarkey points out, Philip Morris still generates an industry-leading operating margin and maintains a wide economic moat, which is reflected in its amazing cash flow generation. The recent market sell-off may have just been caused by short-term worries. This could create a good entry point for patient investors who see an attractive portfolio of strong tobacco brands in Philip Morris. How does Philip Morris plan to keep growing while maintaining its superior margins?
Source: Philip Morris Investor Relations, Presentation slides
The sell-off
It all started at the company's presentation at a global consumer conference on Nov. 20. Philip Morris presented a long-term growth strategy which involves using 2014 as an 'investment year.' The bad news is that the company downgraded its earnings forecast as it plans to increase its 2014 expenditures.
Growth strategies
Philip Morris does have a sound plan to keep its top-line growth alive. First, geographical expansion will continue to play a central role in the company's growth strategy. The company is already exposed to emerging markets, unlike Lorillard and Reynolds American, which are heavily focused on the domestic market. Now, Philip Morris is preparing a new commercial approach to increase its market share in Asia, Africa, and Eastern Europe. These regions are not only doing well in terms of economic growth, they also have attractive population dynamics.
Other Philip Morris initiatives include fighting the illicit cigarette trade and boosting organizational effectiveness. However, the real growth catalyst in this story may be the company's expansion in India, Vietnam, and Bangladesh, where increasing income will allow more smokers to afford premium tobacco brands. Regarding China, the company's joint venture with China National Tobacco to cross-sell Marlboro is a clever way to introduce its products gradually in the world's second-largest economy.
A great product portfolio
The best part of the story is that Philip Morris' expansion should not affect its margins over the long run. The company owns some of the most valuable tobacco brands -- Marlboro and Parliament -- which specifically target the high-end segment. This segment tends to be price inelastic. That said, Philip Morris is also interested in the mid to low-price segment, as evidenced by the marketing expenditures committed to its L&M and Chesterfield brands.
Philip Morris not only covers every market segment, it uses its tobacco supply chain knowledge and marketing expertise to constantly introduce new products. For example, the company will introduce its own e-cigarette next year in an attempt to replicate Lorillard's early success with its blu eCigs brand, which now makes up 4% of Lorillard's total revenue. This is quite an achievement if you consider that the same business unit only accounted for 1% of Lorillard's top line last year.
The recent sell-off could represent an interesting entry point for investors looking for exposure to the tobacco industry. Philip Morris' 40% operating margin reflects its well-diversified portfolio of strong tobacco brands. Surely, as the number of cigarettes sold by Philip Morris per year approaches 1 trillion, its natural to see a slowdown in growth. Philip Morris is not a growth favorite anymore yet it remains an interesting play due to its high margins, its sound plan to keep top-line performance alive, and more importantly its strong branding.
