Philip Morris International 2011 Annual Report Investment Thesis and DCF Update
Introduction/Historical Notes/Preliminary Gloating: Guess what I got in the mail yesterday?….my 2011 Philip Morris International annual report, that’s what! Philip Moris International (“PMI”) (ticker PM) is, along with ExxonMobile, my longest-term holding. I’ve owned Exxon since before it merged with Mobile, and I have owned Philip Morris International since before Philip Morris spun off Kraft, sold a portion of its interest in Miller to SAB (creating SAB Miller, which it still owns over 20% of), changed its name to Altria, and finally spun off Philip Morris International in 2008. Yup, I have owned shares in these companies continuously since 1998, or for going on 14 years now. I also added to my PMI position during the financial crisis, and during the entire past 14 years I have been reinvesting my dividends. It has been a pretty darn successful inflation-adjusted investment for me, epecially in comparison with the performance of the S&P during this time period. PMI used to be my largest single holding, but because I upped my stakes in other companies during the last two years, it is now just in the top four. Pish. I am now updating my PMI analysis, both my mathematical free cash flow analysis and my thoughts on the 2011 annual report, and analysis of its prospects. (To some extent these feed into each other, because future prospects go into setting some of the DFCF assumptions.)
Conclusions: I’ll spare you the agony of waiting until the end for my conclusions: PMI is still very, very investable, and surprisingly is most likely a very good buy at under $80 to $85/share, even after the run-up. I should strongly consider adding, particularly on weakness. (It’s at $87 now.) Last year’s results were abnormally good because of a one-time (and likely temporary) share increase in Japan, the result of last’s year’s earthquake/tsunami temporarily knocking out production at a major competitor, and PMI’s excellent response. Europe was a drag, and will continue to be. 2012 is likely to disappoint in comparison with 2011. Litigation risk is much bigger than I think many “I used to own Altria” investors realize, and may in fact be bigger than Altria’s risks, particularly if your vision extends ten or more years out.
Selected prior assumptions, forgetfulness, and general nonsense: Before doing this analysis my soft thinking was that PMI was overvalued. This was because of certain assumptions I was making about it now being a faddish dividend stock, being a “play on a falling dollar,” about most importantly general negative valuation thoughts following its massive run-up in market-appraised value (i.e., stock price) over the past two years: I was suffering bit from what is known as “anchoring,” whereby I have a hard time getting over the fact that what was recently $45/share is now $87/share (so how could it still be a buy?!) Etcetera.
Discounted Free Cash Flow Analysis and Assumptions: As is my habit and will become even more my habit, I am attaching a link to my discounted free cash flow analysis. It is here if you follow this link. (From now on, I will include a link to these in Google Documents. They may evolve over time. In some I might include a simple enterprise value analysis, which I have in some of my “offline” sheets.) You should be able to view the document, but you cannot edit it. It shows the following:
- There has been recent FCF growth at at bit over 10% last year, with 20+% annualized over the past four years. I have set assumptions of 8% or 9% annualized growth in FCF over the next ten years, as discussed. The spreadsheet currently reflects a 9% assumption.
- I am using a discount rate of 10%. I think this reflects PMI’s stability, mixed with risks that do probably make it more risk than owning a Treasury bond, and my view that using a Treasury rate in today’s low rate environment is probably not reflective of true future cash flow values. Note that some value hounds like a 15% discount rate on everything. I think this is a bit much. The snake eats its tail here, but Warren Buffett famously uses as his discount rate the rate of return on a 30-year Treasury bond. As of now the rate is below 4%. I’ve gotta admit, the issue of choosing the discount rate flumoxes me a bit. On the one hand, I’d like to use the risk-free rate, as Buffett does. On the other, I think it is more appropriate to use a rate more in line with what I estimate (guess) to be the average or more likely applicable discount rate during the entire time period in which I might hold the stock. So I’m using a much higher rate, 10%. The worst result of this is that I am drastically undervaluing the stock. (Lower discount rates result in a higher valuation, as it means future cash flows are worth more). This is my current thinking anyway. Manipulating the discount rate to account for things like risk and the current rate environment is bad, bad, bad from a Buffettian perspective. I’m tracking it. I justify it because in each case my assumptions here are making my analysis more conservative than it otherwise would be. I realize one cannot ever truly compensate for the risk of business failure; I’ll continue to keep my eye on the company.
- Depending upon whether I assume the next ten years of cash flow at 9% or 10%, I get a buy price (20% discount to intrinsic value) of between $79 and $85 per share. That compares favorably with the current share price, notwithstanding the run-up in the stock price over the past couple of years.
Company Performance: I am focused more on return on assets than on return on equity, given PM’s significant leverage. Return on assets remains very steady, now back up in the 24 range. All margins are at or near highs (though note in my “letter to my mother in law” post that I am worried about all-time highs in profit margins).
Currency Risks: I think the extent to which this company is just a “hedge against a falling dollar” is quite frankly not as much as I had convinced myself. The relevant portions of the 2011 annual report are on pages 20, 41, and 67-71. I am NOT an expert, but my read here is that PMI does a very good job of hedging out the vast, vast majority of its currency risk. Nonetheless, this represents a cost for PMI. It also represents a signficant source of risk, that PMI may screw up at some point with its hedging: most likely source of that would be a failure to hedge either for the implosion of the Euro, or for a sudden devaluation or appreciation of either the Yen or the dollar. I am not competent to suss out the extent to which PMI has adequately hedged for this sort of “Black Swan” thing, and frankly I think the publicly-filed documents including the annual report do not make this possible. But overall, I do not think the idea of PMI as a currency-arbitrage opportunity should be considered a part of its investment thesis at all. PMI is really a play on the relative economies of the rest of the world versus the U.S.
Major litigation risks: I was impressed more than ever by the litigation risks that PMI faces. The relevant portions of the 2011 annual report are at pages 24-32. It is very popular to talk about how PMI faces much less litigation risk than Altria does. Investors should read the above section of the annual report….. I would like to propose two things to dampen the enthusiasm of PMI investors. 1) the rest of the world does not have the First Amendment; and 2) the rule of law is not as strong in the rest of the world generally as it is in the U.S. (with extremely notable exceptions in the EU, for example). The First Amendment will prevent trademarks from ever being banned entirely in the U.S. Not so in Australia! — there PMI is presently banned from even having a logo on its products. That is crazy stuff, man, and may happen. Relatedly, as to point two, presently attitudes in much of the world are much less anti-smoking than they are in the U.S. But what if that changes? It is already beginning to change in some places, such as Brazil, and as the annual report points out, thw WHO has now formed a “Framework Convention on Tobacco Control” (“FCTCC”) that has been entered into by 174 countries, and which has the potential to add extremely onerous regulations. More to the point, if sentiment turns against smoking more fully, PMI will face all of the risks that Alrtia faces in the U.S., plus it will face those risks in many cases in countries where the rule of law is weaker (meaning mob rule and/or corrupt, politicized justice) and as a “Big Bad Ugly American (spits) Company”. That has the potential to be a Big, Bad, Ugly scenario. We’re not there yet, but take a look at some of these litigation results in Brazil. The continued economic growth of the developed world will create further growth opportunities, but also further risks of litigation, in environments likely to be worse than what Altria faces in the U.S. Consider yourself warned, and stay on top of it!
No Enron Crap: There are no off-balance sheet entities. Good! See page 39 of the 2011 annual report. No speculative use of derivatives or no use at all of leveraged derivatives. See page 41 of the annual report.
Unresolved Questions and Final Thoughts:
- I am confused by how PMI accounts for and calculates its shareholders equity. This may be my “dumb moneyness” talking, but PMI deducts its treasury stock (stock repurchases) from shareholders equity. This makes shareholder’s equity seem really small (and makes ROE seem really high). It is also not how I have seen this done with other companies. There must be some accounting reason for this, but I think it means the listed shareholder’s equity on the balance sheet is not actually “correct”. I need to take some time at some point to work this out.
- PMIs pensions seem well-funded. Also, it has reduced the discount rate it uses to calculate liabilities, which means that liabilities have gone up. This means that in a normal interest rate environment PMI’s pension gap (which is not actually enormous) will go down or turn to surplus I think.
- PMI has been and remains very indebted. I am happy to see it has used the ZIRP period to lengthen its bond payment structure and to reduce the weighted cost. That should have positive long-term effects for the company.
Morals: People choose to smoke. Everyone knows it is bad for you. And on the positive side, smoking was the first social network. It gives people a lot of interpersonal and physical enjoyment. They also tend to overdo it a lot because it is so addictive. And it kills people, particularly when they do it a lot. I recognize all of these things. My father-in-law recently died of complications of, in part, smoking (also drinking heavily). My dad has smoked crappy cigars manufactured by Altria for the last twenty years, despite my continued exhortations to him to quit it or lower his rate of smoking. I feel no guilt about owning this stock. Another way to think about smoking is that smokers get tons of enjoyment out of smoking, in many cases for decades, and then they impose the externalities of their consequently-poor health on the rest of us by needing greater medical care, the vast majority of which is paid for on yours and my public dime. They ain’t gonna stop doing this because of I don’t buy the stock. The least we can do is profit in some way from the externalities that smokers and tobacco companies impose on us, and from the consistency and seeming permanence of this state of affairs.
Forecast: I think 2012 will turn out to be somewhat of a “disappointing” year for PMI because: 1) the comparison to 2011 results in Japan will be very difficult; and 2) continuing difficulties in Europe, particularly in the PIGS, will likely prove to be even more challenging than last year. These impacts will be somewhat offset by continued growth in the rest of Asia (ex-China…, don’t get me started on that), and in Latin America.