Philip Morris: Even More Bullish After Investor Day

Company Update (PM US) (Buy)

Highlights

• New 2024-26 targets include 9-11% ex-FX EPS growth

• U.S. IQOS plans are phased, reducing near-term earnings risk

• PM leads in key areas like tobacco flavors and wet pouches

• With shares at $92.17, P/E is 16.5x and Dividend Yield is 5.6%

• We see 98% total return (25.6% p.a.) by end of 2026. Buy

Introduction

We are updating our Philip Morris (“PM”) investment case after the company’s investor day last week (September 28).

We believe PM will be the key structural winner from Tobacco’s transition to Smoke Free Products (“SFPs”), and the investor day has strengthened this view. PM has announced new 2024-26 targets that include an acceleration of Adjusted EPS growth to 9-11% (ex-currency), driven by growth in SFPs but backed by a still-robust Combustible business. SFPs are now more than 35% of revenues, and should exceed 50% by 2025, potentially driving a re-rating.

We have also learned more about PM’s U.S. IQOS plans, which will be phased and partly dependent on FDA authorization of ILUMA, reducing the risk in near-term PM earnings though arguably giving competitors more time. Other positive datapoints include the popularity of IQOS’s tobacco-flavor variants, the new LEVIA zero-tobacco IQOS consumable, and ZYN Ultra moist pouches. However, 2023 EPS outlook has been cut by 3% due to currency.

At $92.17, PM shares have a 16.5x P/E relative to 2023 EPS outlook (excluding Russia) and a 5.6% Dividend Yield. We update our forecasts to include a 10% Adjusted EPS growth after 2023 and a 22x P/E at exit, and these now give a total return of 98% (25.4% annualized) by 2026 year-end. Buy.

Philip Morris Investment Case

We have followed Tobacco stocks for over a decade and began publishing our research on PM publicly with a Buy rating in 2019. Since our initiation, PM shares have gained 44% in 4.5 years, including 28% since the start of 2021:

PM Share Price (Last 5 Years)

Source: Google Finance (07-Oct-23).

Our PM investment case has been based on the combination of potentially dramatic upside from Smoke Free Products, notably IQOS Heated Tobacco, and solid ongoing returns from a stable, market-leading cigarettes business. Over the years IQOS has continued to gain momentum, PM has added another leading SFP by acquiring Swedish Match and its ZYN nicotine pouches, and PM is also set to start selling IQOS directly in the U.S. after April 2024. (You can read a recap of our sector views here and one of our PM investment case here.)

PM will be the key structural winner from Tobacco’s transition to Smoke Free, because its share in SFPs is much higher (2-2.5x higher) than its share in cigarettes, and the unit economics in SFPs are a multiple of those in cigarettes (2-2.5x Gross Profit overall). The investor day presentation provided a reminder of this, with PM having a ~50% share of all SFP volumes outside the U.S. and China, including ~75% in Heat-Not-Burn and ~66% in U.S. Nicotine Pouches:

PM Volume Share By Category, Smoke Free vs. Cigarettes (2022)

Source: PM investor day presentation (Sep-23).

Similarly, PM shared their estimates of unit economics, which show that U.S. ZYN is ~6x as profitable as cigarettes outside the U.S., non-U.S. IQOS is about 1.5x as profitable, while U.S. IQOS is expected to be 3-4x as profitable:

PM Unit Economics, Smoke Free vs. Cigarettes (2022)

Source: PM investor day presentation (Sep-23).

(Non-U.S. Vapor, not shown above, was described as being ~1.2-1.3x as profitable as non-U.S. cigarettes.)

PM’s strong performance in SFP market share and economics help drive its new 2024-26 targets.

New 2024-26 Targets

PM announced its 2024-26 targets at the investor day, including:

• Total shipment volume CAGR to be “positive”

• Net Revenue CAGR to be 6-8% organically

• Adjusted EBIT CAGR to be 8-10% organically

• Adjusted EPS CAGR to be 9-11% ex-currency

These targets represent an acceleration from 2021-23 targets, which included a “broadly stable” volume, an organic Net Revenue CAGR of 5%+ and an ex-currency Adjusted EPS CAGR of 9%+. (The latest 2023 guidance implies actual CAGRs of ~1.5%, ~7.5% and ~11.5% respectively will be achieved; however, in dollars, 2021-23 Adjusted EPS CAGR is expected to be a negative -1.0%, or even -4.5% if we adjust out 2023 earnings from Russia as lost.)

PM’s 2024-26 targets are driven by growth in SFPs but backed by a still-robust Combustible business. For the industry, PM is expecting double-digit volume and value growth for all three SFP categories (though E-Vapor is expected to be the slowest and to have flat value per unit), as well as an 1-3% value CAGR in Combustibles (consisting of a 2-4% volume decline and a mid-single-digit pricing growth annually on average):

PM Industry Volume & Retail Value Estimates (2024-26)

Source: PM investor day presentation (Sep-23).

Relative to the total nicotine industry’s expected 2024-26 value CAGR of 3-5%, PM’s own revenue CAGR target of 6-8% implies continuing overall market share gain (and likely some benefit from excise rises lagging value growth). However, PM is not assuming it will maintain the same level of dominance in Heated Tobacco and Nicotine Pouches it presently has, as CEO Jacek Olczak explained during investor day:

“Somewhere in the model we’re assuming that maybe finally there will be some success coming from, you know, two or three of our competitors … We need to be a little bit realistic that maintaining the first-mover advantage of that level for that long period of time.”

In addition, PM also stated there is now price pressure in some SFP markets, notably Japan. Management believe they could increase SFP prices but expect to do so “very selectively”.

We believe these assumptions mean that PM’s revenue targets are realistic. The rest of its targets in Adjusted EBIT and Adjusted EPS can be powered by the same drivers in the traditional tobacco earnings algorithm, including price, positive mix shift (to SFPs), productivity improvements, etc., and are also achievable in our view.

The leverage benefit between revenue growth and EPS growth implied by 2024-26 targets is 3 ppt, one point less than before. Management stated they have taken into account higher interest rates and only assumed a flat tax rate (versus a falling tax rate previously, but not assuming any impact from a potential OECD minimum tax rate.)

We believe the 2024-26 targets are achievable overall.

To Be 50% Smoke Free in 2025

PM has reiterated its aspiration of having SFPs contribute 50% of its revenues by 2025 and more than two-thirds by 2030 (compared to 35.0% in 2023 and 32.1% in 2022). We believe this is also achievable.

A higher SFP contribution can potentially drive an upward re-rating in PM’s valuation, because SFPs do not come with the same structural volume decline associated with cigarettes, and because moving away from cigarettes and becoming part of tobacco harm reduction will improve PM’s credentials among ESG (Environmental, Sustainability & Governance) investors.

U.S. IQOS Plans To Be Phased

The investor day also showed PM’s U.S. IQOS plans, which will be phased and partly dependent on FDA authorization of ILUMA, its more recent version of IQOS Heated Tobacco product based on “induction heating”:

• ILUMA will submit its PMTA (Pre-Market Tobacco Product Application) in October 2023

• Commercialization of IQOS in the U.S. will begin in May 2024 with the test launch of “blade” IQOS (the original version authorized by the FDA) in 4 cities in two states, after the return of U.S. IQOS rights from Altria on April 30.

• ILUMA is expected to receive FDA authorization in 2025, after which it will begin a “national rollout” that will include 10 states over the following 12 months; the 10 states have not been decided.

• Within 5 years of launch (i.e. by around 2029), PM’s ambition is for IQOS to have a ~10% share of U.S. industry volume (defined as cigarettes and Heated Tobacco)

There are likely intermediate steps between the test launch and the national roll-out, but PM did not disclose these.

The phased approach makes sense because PM will need time to fine-tune its approach before a full launch, and management does not want to waste resources and potentially confuse consumers by launching two versions of the IQOS in quick succession. It mirrors IQOS’s successful roll-outs in both Japan and Europe. PM is continuing to invest in its U.S. infrastructure to help grow ZYN in the meantime, and IQOS can leverage on this later.

The phased approach also reduces the risk in near-term PM earnings in terms of both actual costs and revenue expectations. PM expects its U.S. volume, net revenue and Adjusted EBIT all to grow at double-digits annually in 2024-26, driven by ZYN but “including the impact of IQOS investments”.

Making the “national roll-out” dependent on FDA authorization does introduce an element of uncertainty. The successful PMTA process for “blade” IQOS did take only two years (submitted in May 2017, authorized April 2019), and this authorization (as well as the subsequent authorization of its Modified Risk Tobacco Product application) should help ILUMA’s application. On the other hand, the FDA currently has a large PMTA backlog and has yet to decide on applications from many significant products, notably British American Tobacco’s (“BAT”) Vuse Alto.

Any delays in ILUMA’s PMTA authorization would be negative, but likely manageable. As a last resort, PM could revert to using “blade” IQOS in its national roll-out. PM’s phased approach will arguably give competitors more time, though how much they can use this time is limited by the lack of alternative FDA-approved products.

No Heated Tobacco product is currently on sale in the U.S., with BAT having submitted a PMTA for its glo Hyper product in December 2021 and Altria’s Heated Tobacco JV with Japan Tobacco expecting to submit a PMTA only in H1 2025. Instead IQOS’s near-term competition will mainly be from other Smoke Free categories, notably BAT’s Vuse (which has a 47% category share by value but with largely unauthorised products) and Altria’s NJOY (which has authorized products but only a 3% category share by volume) in Vapor.

U.S. Nicotine Market By Volume (2022)

Source: PM investor day presentation (Sep-23).

We continue to believe Heated Tobacco is the best cigarette substitute for existing smokers and IQOS is by far the most popular product in Heated Tobacco. In any case all U.S. IQOS revenues will be incremental, and PM is only targeting for a 10% volume share after 5 years (vs. 26% in Japan and 17% in Italy already reached).

A further implication of PM’s phased approach on U.S. IQOS is that U.S. cigarette volumes are unlikely to be significantly cannibalized by SFPs until 2025 (when the “national roll-out” for ILUMA is expected; we believe Vapor’s impact will remain limited). This is positive for our investment cases on BAT and Altria.

Other Positive Datapoints

Other positive datapoints from the investor day include:

• “Classic tobacco” variants contribute more than 50% of IQOS’ volume in Europe. This means IQOS volumes in Europe are unlikely to be impacted by the European Union’s new ban on flavors in Heated Tobacco (decided in November 2022, to be implemented by member states by October 2023). It also confirms that IQOS can achieve strong growth without flavors; by contrast, 75% of BAT’s Vuse consumables in 2022 were in menthol variants.

• A zero-tobacco IQOS consumable called LEVIA is being introduced. This further broadens IQOS’s product portfolio. LEVIA may also be less burdened by tobacco-specific tax and regulatory burdens in some jurisdictions.

• A moist nicotine pouch called ZYN Ultra has a PMTA application that has been submitted in November 2021. ZYN Ultra cannot yet be marketed, but it will help keep ZYN ahead of Altria’s on!, whose moist pouch product (on! PLUS) is only expecting to have a PMTA submitted in 2024

These reinforce our view that PM will continue to lead the Heated Tobacco and Nicotine Pouches categories.

2023 EPS Outlook Cut by Currency

Less positively, PM’s 2023 Adjusted EPS outlook has been cut by 3% due to currency, from $6.13-6.22 to $5.96-6.05, with currency now expected to be a $0.50 headwind (was $0.33).

Excluding currency, PM continues to expect 2023 Adjusted EPS growth to be in the 8.0-9.5% range.

Russia is included in Adjusted EPS for accounting reasons. Management stated that the contribution from Russia has now shrunk to 6-7% of Adjusted EPS, which is lower than what we assumed (11%).

Valuation: 16.5x P/E, 5.5%+ Dividend Yield

At $92.17, PM shares have a 16.5x P/E relative to its 2023 Adjusted EPS outlook, excluding Russia. (The mid-point of the 2023 Adjusted EPS outlook is $6.01, or $5.58 if we deduct 7% for the business in Russia.)

PM Net Income, Cashflow & Valuation (2021-23E)

Source: PM company filings.

Relative to 2022 earnings excluding Russia/Ukraine but not pro forma Swedish Match, PM shares have a 17.3x P/E, and the Free Cash Flow (“FCF”) Yield is 6.8%.

PM’s 2024-26 targets include $36-39bn of total operating cash flow and $3.5-3.7bn in total capital expenditure, which implies an average FCF of $10.8bn per year. Relative to this, FCF Yield is 7.5%.

The Dividend Yield is 5.6%, with PM shares currently paying a dividend of $1.30 per quarter ($5.20 annualized), which was raised 2.4% in September.

Management expects to deleverage to “around 2x” Net Debt / Adjusted EBITDA by the end of 2026 (compared to 3.24x at the end of Q2 2023). The Board will “consider moving back to a buyback plan” “once we have clarified that we are going to reach this objective”, which we believe will be late 2025.

Philip Morris Stock Forecasts

We raise our 2023 forecast (our previous forecast was lower than the new outlook), increase our post-2023 Net Income growth and also extend our forecasts by 1 year to 2026. We continue to exclude earnings from Russia. We also raise our exit multiple to 22.0x to reflect a greater shift to Smoke Free revenues.

Our new assumptions are:

• 2023 EPS to be $5.58 (was $5.49)

• 2023 dividend to be $5.20 (was $5.18)

• Net Income to grow at 10% annually in 2024-26 (was 8% in 2024 and 9% in 2025)

• Share count to be flat (unchanged)

• Dividends to grow at 2% annually (unchanged)

• P/E at 22.0x at 2026 year-end (was 20.0x)

Our new 2025 EPS forecast is $6.76, 5% higher than before ($6.46); our 2026 EPS forecast is $7.43:

Illustrative PM Return Forecasts

Source: Librarian Capital estimates.

With shares at $92.17, we expect an exit price of $164 and a total return of 98% (25.4% annualized) by 2026 year-end. Including dividends, investors can potentially double their money on PM in just over 3 years.

We reiterate our Buy rating for Philip Morris stock.

Ends

Stocks mentioned: PM 0.00%↑ MO 0.00%↑ BTI 0.00%↑ IMB. We are long PM and BAT.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.