Philip Morris: Mr. Market, The Price Is Right

Philip Morris (PM -1.11%) has underperformed tremendously over the market's current rally, down to a 52 week low, while the overall market continues to make highs. In fact, Philip Morris recently cut 2014 guidance. Many analysts are pointing to the fact that Philip Morris faces a currency headwind to profitability as a result of a stronger dollar, which nips at earnings, seeing that Philip Morris is an international firm. In addition, the decline in cigarette volume consumption year over year has resulted in panic over the future of the cigarette industry down the road as the general population becomes more health conscious. I believe these fears are exaggerated, and given Philip Morris' competitive position, the company is well poised to handle the negative pessimism clouding the stock over the long term. 

Sounds Like Quite The Overreaction...

Over the years, Philip Morris has developed a wide economic moat through an economy of scale and its intangible assets. Philip Morris owns  7 out of the 15 leading international cigarette brands, and as a result of this, the company has incredible pricing power. Some of these brands include Marlboro, Parliament, Virginia Slims, and Chesterfield. This coalition of brands allows Philip Morris to incrementally raise prices each year, offsetting the annual declines in sales volume  of around 5-6%. In addition, the addictive nature of tobacco helps retain some of the business lost through volume declines, as it increases the degree of retention between product and consumer. Don't forget that this is a problem being faced by virtually all companies in the tobacco industry, especially the larger ones such as British American Tobacco (BTI -0.51%) and Imperial Tobacco Group (IMBB.Y 0.22%).

British American Tobacco, Imperial Tobacco, and Philip Morris seem to be trading at 52 week lows, and this truly captivates the negative sentiment felt toward the international tobacco companies. It is worth noting that Philip Morris has the cheapest valuation out of the other big tobacco firms, along with having the highest net profit margin. 

In particular, Philip Morris and British American Tobacco seem to be in the dumps on a P/E basis. Philip Morris, however, is best primed to recover from these pessimistic views. Seeing that Philip Morris is the largest tobacco producer outside of China, the firm is able to drive down per-unit costs and still increase profitability. The strong brand loyalty that the consumer has to Philip Morris' product pipeline is something that I see any competitor having a hard time trying to take away.

Furthermore, Philip Morris has a marketing strategy for penetrating emerging markets that separates it from other tobacco firms such as Altria (MO -0.37%) and Lorillard (LO.DL) that are currently poised more toward the domestic U.S. market. Altria owns the same brands as Philip Morris, but just focuses on the U.S. market while Philip Morris is international only. As a current shareholder of Altria, I have certainly noticed that earnings have continued to see increases, and this is likely due to the fact that the firm doesn't face the same currency headwinds as Philip Morris, as Altria sells all of its merchandise in the U.S. dollar. 

Lorillard, on the other hand, is dabbling in the electric cigarette business, which has begun to gain traction among smokers. Lorillard's Blu e-cigarette division is starting to show rampant growth domestically, capturing half of the U.S. market. The growing e-cig problem is a potential threat to traditional tobacco marketers, however I view the addictive nature of tobacco and its combination with strong consumer product loyalty helps combat this concern. Seeing that Philip Morris has such strong market share in the global tobacco market, it is actually seeing increases in unit volumes in some emerging markets such as Africa, Asia, and Latin America, as looser restrictions on tobacco along with increasing income allows for a better global outlook on Philip Morris's prospects. 

The Valuation is Cheap, But Let it Get Cheaper

Granted, the headwinds faced by Philip Morris may last some time, the firm's wide moat and distribution network is unmatched. Match this with management's strict discipline to continue creating shareholder value over long periods of time, and an investment in Philip Morris appears even more attractive. The company has historically been a free cash flow machine, and management has done an exceptional job reinvesting these cash flows back into the business not only through allocation toward penetrating emerging markets (Asia in particular), but also consistently buying back stock and paying a juicy dividend yield.

I would personally advocate investors to wait for a broader margin of safety. When a stock is being surrounded by pessimism, it can really be a great thing for the bargain-oriented investor, as any bit of negative news can be easily exacerbated by the market. If you focus on what the long term economic value of Philip Morris is instead of getting caught up in the near term slight inhibitors to growth opportunities, then you'll soon realize that Philip Morris is beginning to become a captivating investment opportunity even in this ebullient market.