Thursday is turning into an interesting day for investors in tobacco stocks, as Bank of America-Merrill Lynch announces a pair downgrade/upgrade on Altria (NYSE:MO) stock and its former subsidiary Philip Morris International (NYSE:PM).
Let's start with the good news first. On Thursday, Merrill Lynch announced it's upgrading Philip Morris International stock from neutral to buy, and raising its price target on the shares as well -- to $110. At the same time, however, Merrill is taking an axe to Altria stock. Citing a valuation that it calls "stretched," Merrill is cashing in its chips on formerly buy-rated Altria, and downgrading the stock to neutral.
Now here are three more things you need to know about these moves.
Thing No. 1: Cold feet?
Merrill previously had a $66 price target on Altria, and it's leaving that target in place despite the downgrade.
And yet, from a January low of $57 and change, the stock has climbed only one-third of the way to Merrill's target. With two-thirds of the trip yet to be completed, Merrill's decision to cut bait on its pick suggests it's not really as sure of that $66 price target as it may seem. The fact that Altria shares sell for more than 22 times earnings, but are expected to grow those earnings at barely 8% annually over the next five years, suggests Merrill may be right to be nervous.
Thing No. 2: A "stretched" valuation? Really?
And yet, when you compare Altria stock to Philip Morris International -- the stock Merrill is upgrading today -- it's hard to see why the analyst likes one stock so much more than the other.
Yes, Altria at almost 23 times earnings and 8% growth seems pricey. But by the same token, Philip Morris shares cost nearly 22 times earnings themselves. And according to data from Yahoo! Finance, analysts expect Philip Morris stock to grow its earnings even more slowly than Altria. Consensus expectations call for less than 7% growth at Philip Morris over the next five years!
Thing No. 3: Others are underestimating it
So what is it that Merrill Lynch loves so much more at Philip Morris than at Altria? According to a write-up prepared by TheFly.com, it boils down to this: Other analysts aren't giving Philip Morris enough credit for its growth prospects.
Merrill sees two main factors helping to make Philip Morris International a better bet than Altria. First, Philip Morris' business has been burdened by unfavorable exchange rates that haven't affected domestic manufacturer Altria as much. Exchange rates swing both pro and con, however, and after hurting Philip Morris sales and profits in recent years, Merrill thinks they're about ready to swing back in Philip Morris's favor -- accelerating sales and profits.
The analyst also believes that Philip Morris has been winning market share in the cigarette market, taking share away from both rival brands, and from "illicit trade" -- pirated cigarettes. In each case, gains in the unit-volume of cigarettes sold can combine with gains from favorable foreign exchange rates to turbocharge growth in both revenue and sales.
And one more thing...
If Merrill Lynch is right about this -- and it's a big "if" -- then everyone else might be wrong about the sub-7% growth rate at Philip Morris International. But what if Merrill Lynch is wrong?
Priced at just under 22 times earnings today, and with strong free cash flow that gives it an equivalent price-to-free-cash-flow valuation, Philip Morris International is not a cheap stock on a 7% growth outlook. What's more, according to data from S&P Global Market Intelligence, even the most optimistic analyst following Philip Morris today doesn't expect anything more than 12% growth. (The least optimistic analyst polled by S&P Global expects...0.1% growth.)
Is 12% growth, combined with a 4.2% dividend yield, a big enough return on investment to justify paying nearly 22 times earnings for a stock? I don't think so. But feel free to tell me why I'm wrong...
...on Motley Fool CAPS.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 288 out of more than 75,000 rated members.
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