Philip Morris: Strong in a High Inflation Environment (NYSE.PM).

Thesis on investment

It is crucial to assess the impact of higher prices on businesses in a high inflation environment. Philip Morris (NYSE:PM) is among those few companies who have not only strong financials, internationallyIt has established brands and excellent profitability margins. However, its business is less susceptible to price elasticity and has significant pricing power that can absorb higher input costs. An ongoing success story is possible due to strong sales of its smoke-free products. RecoveryI believe the stock is undervalued in terms of sales growth in low and mid-income markets, as also in the duty-free segment. Its fair price is likely to be $133.83, which is 30.22% higher than its actual level.

A quick look at Philip Morris

Philip Morris International Inc., the world’s largest seller and manufacturer of cigarettes and other nicotine-containing products and smoke-free products, had over 69,600 employees as of 2021. As we have already mentioned declaredPhilip Morris will transition to a smoke-free business in 2019. The company will stop using combustible products and will aim to generate more than 50% of its net revenues with smoke-free products by 2025. Despite the fact that this target may be delayed for 12 months due to the recent conflict with Ukraine, Philip Morris is still making good progress in its transition. In Q1 2022, 30.40% was generated by smoke-free products. Philip Morris offers IQOS smok-free products. These include heated tobacco and nicotine-containing vapors products under the brands HEETS, Marlboro Dimensions and Marlboro HeatSticks.

The most important Geographic areasThe European Union has 39% of the revenue in 2021. The most consistent growth rates over the past 5 years are East Asia and Australia with 19%. South and Southeast Asia with 14% follow.

The company reportedA constant increase in its Gross Margin that accelerated from 63.70% during 2017-2018 to 68.10% at 2021’s end, resulting in 4.33% compound annual growth rate (CAGR) over the past 5 years. British American Tobacco PLC reported the highest average gross margin at 62.10% in 2021. (NYSE.BTI) reported the highest gross margin at 82.10%, Japan Tobacco Inc., OTCPK:JAPAF, 58.84%, Altria Group, Inc., NYSE:MO) reporting 66.03%, Imperial Brands PLC, OTCQX.IMBBY) reporting 36.40%. Philip Morris is the company that reports the highest investment profitability among its peers. It reported a 61.64% ROIC at end 2021 and a Return on Invested Capital (ROIC), of between 43.77% to 64.03% over five years. This compares with the average of 18.47% for peers. The average peer’s average of 1.56% has seen their research and development (R&D), costs rise slightly from 1.29% to 1.95% over the past 4 year. The company’s leverage rate was 1.97 in 2021. This ratio is significantly lower than the 2.41 average of its peers. The cash from operations of Philip Morris significantly increased in 2021, rising 22% to $11.96B. This resulted in $7.20 cash flow per shares, which is significantly higher than the average of its peers’ at $3.7 and growing at 10.10% CAGR for the past five years. The company also reported the highest earnings per share among its peers, $5.83 at the close of 2021, while the average peer’s was $2.75 at the end. This represents a 5.41% annualized CAGR over 5 years.

Philip Morris in high inflation

Inflation can occur for a number of reasons. Inflation is caused by strong demand for a product or service, which leads to higher prices. This is especially true for demand shocks such as e.g. After a prolonged period with flat demand or for products and services that have a limited supply, the price may rise. Cost-push is when the price of a product or service goes up due to higher input prices. This can be caused by e.g. Increased raw material prices, bottlenecks or labor costs, as well as shortages of basic materials, can all lead to cost-push. Instead, build-in inflation is based upon the expectation of rising prices. This refers to goods and services that are currently increasing in price and will continue to increase in the future. The effects of inflation can be magnified by either expansionary monetary policies, where the central banks lower the interest rates and increase liquidity in the economy, or expansionary fiscal policies, where the government intervenes by reducing fiscal pressure in the economic environment and increasing the discretionary income for individuals and businesses, or by increasing government spending and driving up demand in certain industries.

Businesses must be able to preserve their margins in an inflationary environment. This is possible if the company has strong price power and can increase its revenue by raising prices or changing its sourcing strategy to reduce its input costs. Or, by quickly adapting its strategy and prioritizing products with higher margins.

The tobacco industry is subjected to heavy taxes in most developed economies. Massive scale effects and wide sourcing also contribute to products being less sensitive than other input prices. Consumers are most likely loyal and willing to take price increases. They can reduce other expenses before they cut down on their smoking habits or switch to a brand with a lower price, which results in less elasticity in the market. Tobacco companies have strong pricing power through direct pricing strategies. They can also influence prices through a variety price-reducing marketing tactics, such as: The distribution of free samples, coupons, group offers that include a free product or other non-tobacco products when you buy more of the same product, and price discounts through payments to distributors.

Philip Morris owned five of the top 15 global cigarette brands in 2021. Market shareThe brand Marlboro accounted for 9.5% of the total market share, 3.4% with L&M and 2.3% for Chesterfield. Philip Morris accounted for 1.7% and Parliament for 1.7%. The company’s global market share in 2021 was 27.3%, with 23.8% for cigarettes and a 3.5% share of heated tobacco products. As we have seen in the last few years, especially in developing markets, the company will continue its growth in market share for heated tobacco product and profit from its established brand names and strong customer loyalty to keep its leadership in cigarette unit sales in its most important countries. Higher inflation will likely have a smaller impact on total sales. Philip Morris’ broad product portfolio allows it to choose between less elastic brands and higher margin products.

Valuation

The following Discounted cash flow (DCF), which covers a 5-year forecast period, uses 3 sets of assumptions to determine the terminal value and Weighted Average cost of capital (WACC). Philip Morris is profitable and has a solid Free Cash Flow margin (FCF), which I expect to increase over the next years. However, I still consider my valuation model cautious due to its significant impact on the DCF valuation.

The valuation includes higher interest rates which will undoubtedly be a reality for many economies worldwide over the next years and result in a higher weighted average capital cost.

My modelization shows that the most likely scenario, the mid-valuation scenario prices the share at $141.37, or 37.56% more. The low-valuation scenario which I still consider quite probable, sees the share priced at $112.60, or 9.56% higher, than the actual price. The stock is priced at $181.06 in the most optimistic scenario, which I also consider to be the least likely based on my modelization. It has 76.18% upside potential. I then compute my opinion on the likelihood of different scenarios. This gives me a weighted price target with 30.22% upside at $133.83.

Risk discussion

RRPs are important for the company’s future growth. However the introduction of these new products could be denied by regulators. The communication and marketing options may also be limited and make it difficult to implement a successful marketing strategy. Philip Morris could experience a decline in combustible tobacco product consumption, which could have a significant negative impact on its revenue and profitability. It is therefore important to increase and accelerate sales to offset any loss. RRPs could also be subject to inflation and fluctuations in quality as the company relies more heavily on third-party contract manufacturer and service providers for its electronic devices. Philip Morris is still being sued in tobacco-related litigations in various countries. RRPs are also subjected to legal and administrative challenges regarding product classification, advertising restrictions or scientific substantiation. The company was compelled to respond to the recent conflict in Ukraine. Reduce its activityUkraine and things to consider Completely exitingThe Russian market made up nearly 10% of total shipment volume and around 6% in Philip Morris’ net revenues for 2021.

Market timing

The stock reached its all time high (ATH) of $123.55 on June 20, 2017, but soon began a downtrend, losing approximately 55% of its value before finally reaching its bottom at $56.01 in March 23, 2020. Technical analysis points out that the stock has been trending sideways and showing more volatility since breaking from its ascending trend on September 28, 2021. The stock has recently rebounded from mid-March 2022. It is now at a higher level and showing relative strength compared to major indexes that have dropped significantly over the past weeks. The stock will be able to determine whether it heads back towards the March lows or those from November 2021. Or if it can now establish a solid base from which to break out of its sideways trend and continue its climb.

The $99.06 and $91 support levels are the most relevant in the short term. The closest resistance levels are now located at $106 and $112. The stock is trading above its EMA50 support level and the EMA10, which is its trailing support since March 2022. Before it can break out above the mentioned resistance levels, I believe that the stock will need to reduce its volatility and establish a solid base. Philip Morris can count among its prominent institutional investors. ShareholdersInstitutions own 75% of the outstanding shares and the short interest rate is 0.68%. Long-term investors may be able to take advantage of this potential price level to establish their long-term position. However, they should keep in mind the volatile and uncertain market conditions. If the stock has not been invested in by momentum and position traders since the breakout, they can now see if the current levels will be maintained and if a base is formed or if the stock will be dragged down by the market’s higher volatility. The stock’s relative strength compared to the S&P 500 is encouraging. However, there is always the possibility of new lows.

The bottom line

Investors want to find companies that are less affected by price increases and can mitigate this risk in a high inflation environment. Philip Morris, while not immune to an inflationary cycle in the economy has the tools and capacity to reduce its exposure at higher input prices. It also has enough price power to maintain higher levels of profitability. It’s a great investment opportunity for long-term-oriented investors looking for a safer harbor during high inflation times with a solid yield. It’s also a very interesting share for short-term or momentum traders due to the volatility associated with strong financials, a forward-looking business, and strong financials.