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Morningstar | PM Updated Forecasts and Estimates from 03 Dec 2018

We are maintaining our wide moat rating and $102 fair value estimate for Philip Morris International following the company's respectable third-quarter results. Earnings per share of $1.44 beat our estimate of $1.36 comfortably, but we shall not make material changes to our forecasts and expect a slowdown in the fourth quarter due to technical reasons and investment in new product launches. Nevertheless, with pricing up close to 7% this year, PMI is currently performing slightly ahead of our medium-term assumptions. Although the stock gapped up in U.S. trading, we still believe PMI, along with the rest of the large cap tobacco group, is trading significantly below its intrinsic value, primarily because investors are misinterpreting the impact to cash flows of the slowdown in heated tobacco.

The primary driver of PMI's third quarter beat was strong cigarette volumes, which declined by 1.7% on a reported basis and by just 1.2% after adjusting for trade inventory movements. These solid volume figures were partly supported by heated tobacco unit volumes that slightly missed our estimate, but also imply that PMI is probably winning share to the tune of around half a percentage point globally. This is significant because the company's medium-term guidance relies on share gains, and our cash flow forecasts do not, so if PMI continues to outperform the market on volumes while taking mid-single-digit pricing, there may be more upside to our valuation. In the third quarter, both the Middle East & Africa and South & Southeast Asia segments delivered volume growth.

The key question for tobacco company valuation, in our view, is the trajectory of margins, and on this score, PMI delivered encouraging results. The reported EBIT margin growing 80 basis points to 42.1% from the year-ago period. This is likely a result of strong pricing and some cost savings, but also supports our thesis that the greater-than-expected skew to combustible volumes is beneficial to margins.

We anticipate the launch of iQOS 3 and 3 Multi in Japan and Korea imminently, and in other markets later in the fourth quarter. The short-term impact to the income statement, however, is likely to be limited, with a modest boost to revenue from the device sales, primarily from replenishment sales to existing iQOS users, but a double whammy drag on margins from a negative mix effect and spending around the launch. While the third quarter was strong, therefore, we are not getting carried away and we remain comfortable with our full-year estimates being at the high end of management's guidance. Beyond 2018, we continue to forecast revenue at a 4% CAGR, modest margin expansion from the implementation of the ZBB program, and EPS growth at a 7% CAGR.