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Will Marijuana be Philip Morris’ Salvation?

By Jim Pearce on April 26, 2018

On paper, at least, cigarette manufacturer Philip Morris International (NYSE: PM) appears to be a bargain due to its high dividend yield (5%), low forward PER (14 times this year’s estimated profits), and gradually rising cash flow over the past three years. In addition, the company is one of the big Trump tax cut winners as it paid an effective annual global tax rate of 40% in 2017, which it estimates will max out at an effective tax rate of only 26% this year.

However, its share price tumbled 15% on April 19 after the company released first-quarter results that fell short of analysts’ expectations. Due to dwindling global demand for cigarettes, Philip Morris reported a 5% decline in cigarette shipments by volume. However, the company also announced a 35% hike in its earnings estimate for 2018, thanks primarily to the tax cut.

If ever Philip Morris was given the opportunity to redirect its future path away from the cigarette business, now would appear to be the optimal time. It has the cash to do so, and its current trajectory appears to be a death march to oblivion as more countries either outlaw cigarette consumption or impose onerous taxes that make it prohibitively expensive.

Desert Storm for Tobacco Products

Philip Morris need look no further than Saudi Arabia to get a sense of what the future holds for the industry. In June 2017, the Saudi government enacted a 100% excise tax on cigarettes that immediately drove down the company’s sales there by 41%. As other developing nations follow suit, Philip Morris will find itself squeezed out of its major international markets.

In anticipation of that fateful day, Philip Morris has invested more than $4 billion in the development of “RRPs” (reduced-risk products) such as vapes and heated (non-burning) cigarettes. That may shore up sales in the near-term, but in the long run it will not provide a growth path for future earnings. How Philip Morris chooses to invest its massive tax cut windfall over the next few years will determine its long-term outcome.

That’s true of many legacy industrial businesses that now find themselves on the wrong side of macro trends in global consumption. Onetime computer mainframe giant International Business Machines (NYSE: IBM) has spent the past six years furiously reinventing itself as more of an A.I. (artificial intelligence) cloud-based solutions provider. Thus far, it has no net increase in its stock value to show for it but recently has shown signs of coming back to life.

Pot to the Rescue?

The example of IBM illustrates how difficult it can be for a huge company to change direction. Even with its abundant cash flow, loyal customer base, and talented management team, IBM has struggled to balance the need to invest in its fast-growing “strategic imperatives” businesses while still devoting sufficient resources to service its existing customer base.

For Philip Morris, the challenge could be considerably greater. Other than the smokeless tobacco products that it already offers, there is no adjacent sector for it to gradually migrate, with the possible exception of marijuana. Two years ago, Philip Morris invested $20 million into an Israeli company that makes cannabis inhalers. These devices are not dissimilar from the vaping products the company already sells.

Although still a few years away, at some point Philip Morris may decide to make a huge bet on making marijuana its primary focus. Canada is moving towards legalizing recreational use of marijuana later this year, giving Philip Morris the opportunity to evaluate the logistical challenges of leveraging its investment in Rothmans Benson & Hedges extensive cigarette distribution system in Canada to include marijuana. The opportunity costs of doing so would be minimal to Philip Morris since Canada does not rank among the cigarette industry’s top foreign markets.

However, the upside potential could be enormous since Canada may be the model that most developed countries follow if it is successful. Although Philip Morris has not yet formally included marijuana sales in its future revenue guidance, I believe it may do so later this year after the legalization of marijuana in Canada becomes the law of the land. If so, then this moribund company may once again capture the imagination of investors, in which case its current share price may look like a real bargain a few years from now.


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