Join Date: Mar 2008
Location: San Diego
My Ride: BMW
This is the article I came across last night, I own a little BTI but am looking to buy some PM
Originally Posted by GRIFFIN
can you give more info on that?
There have been some interest and opinions voiced on the subject of international tobacco companies. I figured since I am relatively familiar with the space I would give my thoughts.
First, a personal disclosure. I do work in the investment management industry and have completed all three levels of the CFA examination after obtaining my bachelor’s degree in finance. I also own a large percentage of my personal net worth in PM and BATS-LON, so I do have skin in the game so to speak. Now onto the fun stuff….
The international tobacco market is dominated by four firms: Philip Morris International (PM), British American Tobacco (BATS-LON or the ADR is BTI), Japanese Tobacco (JPN 2914) and Imperial Tobacco (IMT-LON). Together, these firms control roughly 70% of the market share for cigarettes and tobacco products sold outside of the US and China. Investors exclude these two countries in the analysis because most international players have no US exposure since domestic companies like MO, RAI and LO dominate that market and the Chinese tobacco market is a monopoly with a state owned firm having 99% market share. This high market share shows how consolidated the market for tobacco is abroad. This gives companies like PM and BTI large pricing power to customers and suppliers giving PM and BTI large profit margins. EBIT margins for 2011 were as follows: PM 43.2%, BTI 27.7%, Japan Tobacco 21.2%, IMT 18.4%. PM and BTI have some of the largest ratios because they have the best brands, the best production facilities and largest sales bases allowing for fixed cost leverage.
Volumes: Most of the investment community is concerned about the volume outlook for cigarettes. Cigarettes are very unhealthy and prolonged use of these products will no doubt increase a user’s risk of cancer and other very serious health issues. As such, volumes in the US and other developed markets have been falling at roughly 1%+ per year as usage drops. However, this is where PM and BTI shine compared to their US peers. Because PM and BTI have Emerging Market (EM) exposure, where volumes are flat to even growing in some cases, overall volumes for most international players are actually flat to falling slightly. For PM and BTI, overall volumes are likely to be flat to down -0.5% per year for the medium to long term. PM and BTI offer a superior EM profile as compared to Japan Tobacco and Imperial so I tend to focus on them more.
Pricing: The real kicker for cigarette companies is that because nicotine is addictive, demand for tobacco is very inelastic; large increases in pricing are offset by much smaller decreases in volumes. The typical algorithm for revenue growth is roughly -1% to 0% volume growth plus 4-5% annual pricing suggesting long term revenue growth of 3-5% per year. This is hugely beneficial for tobacco firms because they can rationalize production quickly to offset lower volumes. This constant pricing and active restructuring of the cost base insures rising revenues will drive solid EBIT growth.
Taxes: Many people in the investment community argue that increased regulation and taxes from the government will hurt long term volumes. While volumes may indeed get hit by new regulations, investors (me included) should be glad when these actions occur. First, rising tax increases give tobacco companies cover to bump up pricing on the back of those price increases. Because the amount per pack going to the company is small relative to the tax, large % gains on the pack going towards the companies are very small in relation the nominal cost of the pack. With regards to stricter regulations, this also benefits current competitors as it raises the cost of doing business preventing new entrants from entering the market. Less competition is a boon for pricing and margins. When was the last time you saw a start up cigarette producer in the US?
Profitability and return of capital: Any investment that I look at (and I strongly recommend that ALL your investments follow this regardless of what they are) is simply the present value of all cash you expect to be returned to you at some discount rate appropriate for its risk and market conditions/returns on other investments. Investments are simply cash outlays with the idea of more cash inflows later on. Tobacco companies have offered substantial historical returns because of their ability to generate substantial Free Cash Flow and then return that cash back to shareholders in the form of share buybacks and dividends. These two levers have been so strong for Tobacco companies because they have rationalized what they reinvest in the business. New sales require additional capital, usually in the form of a new factory, new inventory, etc. Because Free Cash Flow is equal to Operating Cash Flow less Capital Expenditures, not needing to spend a lot on capital expenditures yet still able to grow EBIT is hard to do. But Tobacco companies do it well mostly because of the factors listed above (pricing, volume, taxes, etc.)
Additionally, tobacco companies generate high ROIC or Return on Invested Capital. Roughly, it shows for all factors of capital invested in the business (net working capital, PPE, intangible assets, cash, etc) how much the firm earns on that. A firm is said to earn Economic Value when ROIC is above the company’s Weighted Average Cost of Capital or WACC. Tobacco companies enjoy an intoxicating mix of a high ROIC business that requires very little capital to grow the business, with the excess capital generated being returned to shareholders. This is as close to the holy grail of investing as one could get (if only it didn’t kill.)
But couldn’t plain packaging kill the business??: People are really concerned about Australia’s plain packaging law and rightfully so. Essentially, no more red Marlboro packs for PM in Aussieland. This threat is overdone. Australian is one of the smallest tobacco markets and one of the most progressive when it comes to smoking laws. Companies like PM and BTI, which are roughly 50-60% exposed to EMs, have little exposure to regulations in developed countries. Growth in the EM business for PM and BTI will more than offset any issues in Developed Markets.
Emerging Markets are the story for PM and BTI. India, Indonesia, Russia, Malaysia, Bangladesh, Turkey, the Middle East and Africa are all huge opportunities for these firms as incomes are rising and smoking rates are high and sometimes even going up. The size of these markets is substantial. India is 10% of the world’s smoking population and Indonesia is roughly 5%, as is Russia. As comparison, the US has 5% of the world’s smokers.
China, the Wild Card: Because tobacco is such a great business, governments have naturally tended to own it in their own country. In fact, many of the early in roads to EM tobacco companies have been joint ventures with state owned firms. China is no different, with 99% of the market owned by the state monopoly firm and 1% being licensed out to PM and BTI (they provide packaging but the State owned firm does the production and selling). China is a massive market for cigarettes with roughly 300MM male smokers (population of the US) and 30% of the world’s smoking population. With smoking prevalence rates flat and incomes rising, PM and BTI would love to get into that market to premiumize and consolidate it. This is a huge opportunity that I think could happen in our lifetime as China has a recent record of spinning off once state owned industries and letting private companies in.
Valuation: Using a DCF with a 10% discount rate and 2.5% terminal EBIT growth rate, I think PM is worth roughly $100-105 per share and BATS-LON is worth between GBP 3750 - GBP 3850 per share. The conversion to the ADR (which is worth 2 shares) gives a FV of between $115-120 for the ADR (ticker symbol is BTI).
I would look to buy these on pullbacks, specifically at 15-20% discounts to FV. That would be $85 for PM and $100 for BTI. Right now I prefer BTI as they have better EM exposure, better opportunities to rationalize the cost base and it is cheaper vs. PM. But if you are an US investor, it may be best to hedge the USD/GBP exchange rate since BTI is traded in GBP. I don’t for my holdings but that is a different discussion entirely!