EUR 850.00 For Business Accounts Only

Morningstar | PM Updated Forecasts and Estimates from 15 Oct 2018

We are maintaining our wide moat rating and $102 fair value estimate for Philip Morris International following the company's analyst day in Lausanne, Switzerland. We think the biggest news to come from the event was the announcement of a new zero-based budgeting strategy, intended to deliver $1 billion in cost savings by the end of 2021, and we think this supports our thesis that without action on costs, Big Tobacco is at or close to peak margins.

Another key takeaway was the announcement of new medium-term guidance to 2021 of at least 5% organic sales growth, 8% CAGR EPS growth, and heated tobacco unit volume of 90 billion-100 billion sticks. The company revealed a little more about its product innovation, and we retain our belief that the reduced-risk product, or RRP, pipeline should be able to attract late adopters to the heated tobacco category. The biggest question for investors, in our view, remains the margin on heated tobacco, and the investor event shed little new light on this metric. Until investors can feel greater conviction in the cash flow forecasts, therefore, sentiment may remain low, but it is this uncertainty that we believe is creating an opportunity in tobacco, and we see significant upside to all four of the large-cap stocks under our coverage. The market appears to be pricing in a very dire scenario, but we believe that even if heated tobacco fails to live up to its billing, the strength of the core combustible business, which has been evident in recent years and was emphasised at the investor day, means that tobacco companies will revert to a very strong and predictable free cash flow stream.

Management lowered 2018 EPS guidance to $4.97-$5.02 per share from $5.02-$5.12 due to unfavourable currency movements, and the headwind to EPS from currency is now estimated to be $0.12 this year. Most of this incremental impact is from the depreciation in the Turkish lira.

We think management's medium-term guidance of at least 5% revenue growth is somewhat optimistic. Based on the growth algorithm of recent years, during which price/mix has averaged around 6.5% and industry volumes have declined by between 2% and 3%, getting to 5% revenue growth would assume that PMI will take share to the tune of around 1 percentage point of their revenue. This has certainly happened in Japan over the past two years, as the first-mover advantage generated by the early commercialization of iQOS has led to share gains from competing cigarette brands. However, both British American Tobacco and Japan Tobacco have commercialized competing heated tobacco products in multiple markets, and we expect PMI's first-mover advantage to be more limited going forward. Our base-case assumption assumes 4.2% revenue growth between 2018 and 2021, and 4.6% between 2019 and 2021, with 6.5% pricing being partially offset by volume declines of 2.5%, more in line with the industry.

We are more optimistic about the target of 8% medium-term EPS growth, however, based on the announcement of a zero-based budgeting strategy. In our recent report on the tobacco industry, "Smoke & Mirrors: Tobacco Valuations Detached from Valuations," we expressed concern that the growth of cigarette substitute products in the portfolios of the large-cap manufacturers would be detrimental to margins. We recently lowered our moat trend ratings to negative from stable as a result. The announcement of the zero-based budgeting policy was a surprise, but it supports our thesis that the customer acquisition cost in PMI's RRP portfolio is likely to be much higher than that of cigarettes, and the sustainability of current margins will require greater efficiencies in the cost structure. Management is targeting $1 billion in cost savings by the end of 2021, and we assume that half of this is returned to the business in the form of higher customer acquisition spending. Further assuming that the debt-reduction policy keeps interest expense roughly flat, we estimate the savings could add 170 basis points to the EBIT margin by 2021, and that this would drive EPS growth very close to the 8% guidance level. This is slightly more aggressive than our previous assumptions, although its impact is muted by a more conservative longer-term assumption of 3.25% EBI growth (down from 3.75% previously) and thus has no material impact on our valuation.

One pillar of our positive view on tobacco stocks is that the pipeline of new products can reignite growth. While PMI revealed more details about its upcoming product launches, we were disappointed that Teeps, the disposable heated tobacco product sometimes referred to as platform 2, will not be launched imminently in new markets. PMI has discovered that high levels of humidity can lead to the carbon tip being disengaged from the stick, so the expanded commercialization of the product beyond the Dominican Republic, where it is currently in marketing trial, has been delayed. We think Teeps could ultimately be an attractive value proposition to late adopters, and we think it may help to reinvigorate heated tobacco category share in Japan. Humidity during the summer months in Japan and other parts of Asia represents significant brand risk, however, and the launch of the product in Asia may be several months away. Still, PMI did provide some details on its immediate product pipeline, with the upcoming iQOS 3 and iQOS 3 Multi models, which should offer improved charging functionality. This may retain customer loyalty in the renewal decision, but the incremental improvements are unlikely to move the needle on the late adopters, in our view.

Mr. Market has displayed wild mood swings in the tobacco sector over the past 12 months as investors have struggled to come to value the potential impact of NGPs. Last year, tobacco was the darling of consumer staples; this year, heated-tobacco growth has slowed and investors have run for the exit. We think the pendulum has swung too far to pessimism, and that current valuations seem to offer value. Similarly, the 33% decline in Philip Morris International since its peak in June 2017 appears overdone. Investors may be disappointed that early adopters of iQOS peaked at around 20% of the market in Japan, but at 15 times forward earnings and with a 5.5% dividend yield, PMI trades at a valuation premium to Imperial but still offers significant value, in our opinion.