Shares of Philip Morris International (NYSE: PM) slid nearly 40% in 2018, as investors fretted over declining smoking rates, competition from British American Tobacco's (NYSE: BTI) takeover of Reynolds American, currency headwinds, and higher interest rates making its dividend less attractive. The broader sell-off across the markets exacerbated that pain.
However, two analysts recently issued extremely bullish forecasts for the tobacco giant. In November, Wells Fargo analyst Bonnie Herzog reiterated her $100 price target for PMI, stating that it had "reached an inflection point" on positive trends in its cigarette and IQOS businesses. Herzog recommended PMI as a core holding for investors in 2019.
In December, Piper Jaffray analyst Michael Lavery, who has a price target of $110 on PMI, pointed out that PMI's "cigarette business remains strong, with pricing power still intact." According to Lavery, PMI's sell-off was "overdone," that the company was still generating robust earnings and free cash flow growth, and that IQOS had "proven traction with consumers."
As of this writing, only one analyst rates PMI as a "sell," while most are telling investors to buy or hold the stock. Investors should always take analysts' ratings with a grain of salt, but could PMI really rebound more than 50% in 2019? Let's take a closer look at its business to find out.
Understanding PMI's strategy
Altria (NYSE: MO) spun off PMI a decade ago to handle the company's overseas businesses. That move enabled PMI to pursue aggressive growth in countries with higher smoking rates, while allowing Altria to streamline its domestic business, focus on cutting costs, and handle lawsuits in the U.S. However, the split also left PMI exposed to volatile currency exchange rates and economic challenges in certain markets.
Despite those challenges, PMI is generating stronger growth than Altria, and it's immune from the Food and Drug Administration's tighter anti-smoking regulations in the U.S. market. During the first nine months of fiscal 2018, PMI's retail market share rose 30 basis points to 38.4% as its total (cigarette and heated tobacco) shipments increased 0.3% (after excluding the impact of trade inventory movements) to 579.3 billion.
PMI's traditional cigarette shipments fell 2.7% annually to 550.1 billion, but that decline was fully offset by its growth in heated-tobacco (IQOS and HeatStick) shipments, which surged 42% to 29.2 billion units. PMI bulls believe that robust demand for its IQOS devices, which heat-branded tobacco HeatSticks instead of burning them, will stabilize PMI's business. PMI sells these devices on a razor-and-blades model -- it sells the IQOS unit at a low margin to lock in sales of the higher-margin HeatSticks.
Japan is currently PMI's biggest IQOS market. Last quarter, it reported a "stable quarterly HeatSticks share on a sequential basis" in that country, which gives it the momentum to launch new devices like the IQOS 3 and IQOS 3 Multi.
Demand for IQOS is also strong in Europe and Russia, where its HEETS HeatSticks already account for over 1% of both regions' tobacco markets. Looking ahead, PMI plans to grow IQOS' market share in South Korea and other markets, which should boost the brand's 1.7% share of the global cigarette and heated-tobacco market (excluding the U.S. and China) over the long term.
PMI continues to offset lower shipments of traditional cigarettes with price hikes, cheaper manufacturing costs, and other cost-cutting strategies. These moves boosted its adjusted operating income 5.3% annually during the first nine months of 2018.
All of PMI's growth metrics look much healthier than Altria's ongoing declines in shipments, market share, and operating margins in the U.S. PMI is also able to grow its adjusted EPS without aggressively repurchasing shares like Altria has -- since much of PMI's cash remains overseas and volatile exchange rates could render its buybacks wasteful.
Is PMI headed back above $100 per share?
PMI was often hammered in 2018 by negative headlines about the U.S. tobacco market, which faces tougher FDA regulations. Yet PMI was clearly a baby being thrown out with the bathwater, since it generates all of its revenue overseas.
Analysts expect PMI's revenue and adjusted earnings to rise 3% and 5%,respectively, next year, and it pays a forward dividend yield of nearly 7%. That high yield and its low forward P/E of 13 indicate that PMI is now an undervalued income stock -- a label I refused to use when the stock traded in the mid-$80s in early December.
So, for now, I agree with the bullish analysts. Investors who buy PMI in the high $60s could be well rewarded after the market notices that it's faring much better than Altria and that IQOS could become a major growth engine within a few years.
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