Philip Morris: Positive Q3; Putting That 1.5% FCF/Share CAGR in Context

Company Update (PM US) (Buy)

Highlights

• IQOS In-Market Sales grew 19.3% in Europe and 14.9% in Japan

• ZYN grew its U.S. volume by 65.7% and gained market share

• In € and ex. Canada loss, FCF/Share CAGR was 9.2% in 2018-22

• More stable volume and mix shift since 2018 imply strong EPS growth

• At $90.92, we see 102% total return (26.8% p.a.) by end of 2026

Introduction

Philip Morris (“PM”) released Q3 2023 results last Thursday (October 19).

Q3 results were strong. Year-on-year total cigarette and Heated Tobacco shipment growth was again positive at +2.2%. Heated Tobacco In-Market Sales grew 19.3% in Europe and 14.9% in Japan. U.S. nicotine pouch shipments grew 65.7% year-on-year, with ZYN accelerating its growth and gaining market share. Cigarette shipments fell only 0.5%.  Adjusted EBIT margin improved sequentially, and Adjusted EBIT grew 12.1% year-on-year in dollars. Full-year 2023 guidance was revised slightly, with expected Adjusted EPS growth raised 10.0-10.5%.

We also review PM’s longer-term track record. While it is true that Free Cash Flow / Share (“FCF/Share”) has only grown with a CAGR of 1.5% in dollars since 2013, this ignores the impact of currency and the difference IQOS has made. Starting our comparison from 2018, using Euros and adjusting for Canada, FCF/Share has grown at a CAGR of 9.2%. More fundamentally, volume decline has slowed to around 1% annually since 2018 and the mix has shifted to Heated Tobacco and away from Indonesia and the Philippines. PM has far greater earnings power than 5 years ago.

At $90.92, PM shares are at 16.1x expected 2023 EPS (excluding Russia) and have a Dividend Yield of 5.7%. Our forecasts indicate a total return of 102% (26.8% annualized) by 2026 year-end. Buy.

(For a recap of our investment case, see our review of PM’s investor day published on October 7.)

Philip Morris Q3 Results Highlights

Q3 results were strong. Year-on-year total cigarette and Heated Tobacco shipment growth was positive at +2.2%:

PM Key Volumes & Financials (Q3 2023 vs. Prior Year)

Source: PM results release (Q3 2023).

Heated Tobacco Unit (“HTU”) shipments grew 18.0% year-on-year, while cigarette shipments fell only 0.5%.

Year-on-year, HTU shipments grew by a double-digit percentage in both Europe and the East Asia, Australia & Duty Free (“EA, AU & Duty Free”) region (primarily Japan and Korea); it grew only 4.4% in South & Southeast Asia, CIS & Middle East Africa (“SSEA, CIS & MEA”) because PM has reduced its efforts in Russia, the main HTU market there:

PM HTU Shipments by Region (Q3 2023 vs. Prior Periods)

Source: PM company filings.

Sequentially, HTU shipments grew by 12.4% in Europe, but were 4.5% lower in EA, AU & Duty Free because Q2 benefited from inventory movements; relative to Q1, Q3 HTU shipments In the latter were 11.5% higher.

Heated Tobacco In-Market Sales showed similarly strong growth, up 19.3% in Europe and 14.9% in Japan year-on-year. They also showed continuing sequential growth in each region, though their Share of Market (“SoM”) figures have been more volatile, due to seasonality in cigarette consumption (particularly in Europe, also visible in 2022):

PM HTU Share of Tobacco Market & Volume – Europe & Japan

NB. “European Union” includes the U.K. Source: PM results presentation (Q3 2023).

U.S. nicotine pouch shipments grew 65.7% year-on-year, with ZYN accelerating its growth and gaining market share. As of Q3 2023, ZYN had 70.8% of the U.S. nicotine pouch category by volume and 75.9% by retail value:

PM ZYN U.S. Shipment Volume & Market Share (Rolling 12 Months)

Source: PM results presentation (Q3 2023).

Net Revenues grew 9.3% organically year-on-year (excluding acquisitions). Including both currency and the Swedish Match acquisition, Net Revenues grew 13.8%.

Adjusted EBIT margin improved sequentially, from 39.4% to 40.8% (though still lower than Q3 2022’s 41.5%), as PM’s margin profile continues to progress from the trough in Q4 2022 as management has guided:

PM Adjusted EBIT Margin by Quarter (Since 2019)

Source: PM results releases. 

Adjusted EBIT grew 12.1% year-on-year in dollars (including Swedish Match), or 11.3% organically.

2023 Outlook Revised Slightly

Full-year 2023 guidance was revised slightly, with management now expecting:

• HTU shipments of 125-127.5bn (was 125-130bn) (implying growth of 14.5-16.8%)

• Nicotine pouch shipments of 390-410m cans (was 370-400m)

• Net Revenue growth of around 8% (was 7.5-8.5%)

• Adjusted EPS growth of 10.0-10.5% (was 8-9.5%)

2023 Adjusted EPS is now expected to be $6.05-6.08 (was $5.96-6.05).

The 2% reduction in the top end of the HTU shipment guidance was attributed to a further delay in the market launch in Taiwan, “limited underlying growth in Russia”, and uncertainty around the impact of the E.U. Heated Tobacco flavor ban (effective in all member states on October 23) on inventory levels. We do not believe this is a concern.

1.5% FCF/Share CAGR Since 2013

Some market participants have expressed concern about PM’s earnings growth, with one analyst writing recently that:

“Since the end of 2013 - i.e. just prior to the launch of IQOS - PM has grown Free Cash Flow per share at only 1.5% CAGR in dollar-terms. ‘Adjusted diluted EPS, excluding currency’ is not going to pay the bills.”

The 1.5% figure is factually correct. In fact, PM’s Adjusted EBITDA was lower in 2022 than in 2013 ($13.8bn vs. $14.7bn). However, Heated Tobacco did not become a significant category in Japan, its first major market, until 2017:

Heated Tobacco Share of Total Market – Japan (2013-20)

Source: PM investor day presentation (2021).       

More importantly, we believe focusing on the FCF/Share CAGR since 2013 misses important points, including currency and the impact of IQOS since 2018.

The chart below shows PM’s FCF/Share and Adjusted EPS in 2013-22, as well as some adjustments we have made.

PM Per-Share FCF and Earnings (2013-22)

Source: PM company filings.

First of all, Adjusted EPS was smaller than FCF/Share in 2019-22, so arguably in fact understated earnings. The reasons Adjusted EPS was smaller in these years were that working capital brought in cash and CapEx was smaller than Deprecation & Amortization each year.

Second, while it is true that FCF/Share in dollars has only grown with a CAGR of 1.5% in 2013-22, this included a period of substantial decline in 2013-18 (largely due to currency); simply comparing with 2018 figures instead would give us a 2018-22 FCF/Share CAGR of 5.1%:

PM FCF/Share – Reported vs. Adjustments (2013, 2018 and 2022)

Source: PM company filings.

(In fact, starting from 2014 FCF/Share of $4.19 would also give us a 2014-22 FCF/Share CAGR of 5.1%.)

Third, PM lost about 5% of its earnings when its Canadian subsidiary was put into administration in March 2019 as a result of historic litigation related to the health impact of cigarettes. This was worth $0.26 of EPS in 2018 and, if we were to add back the same to 2022 FCF/Share, we would get a 2018-22 FCF/Share CAGR of 6.1%.

Forth, the Euro is a more representative currency for PM, given the E.U. generated 46% of its Adjusted EBIT in 2022 (whereas PM had no presence in the U.S. until December 2022). The average U.S. Dollar / Euro rate has strengthened by a CAGR of 2.6% in 2013-22 and a CAGR of 2.9% in 2018-22. Adding back a flat $0.26 Canada contribution and converting all figures to Euros give us a 2018-22 FCF/Share CAGR of 9.2%.

Note that all figures include Russia, as we do not have sufficient information to adjust it out. PM’s scaling down of new commercialization activity in Russia and the decline in its currency after the invasion of Ukraine in February 2022 have both been significant negatives for PM’s FCF/Share growth.

Nonetheless we believe the 2018-22 “FCF/Share – Flat Canada (€)” CAGR of 9.2% is much more representative of PM’s current growth profile. However, even this figure does not fully reflect PM’s medium- to long-term potential, because of the supply chain disruptions and IQOS expansion costs (including with ILUMA roll-out) in 2022. CapEx has also been scaled up in 2022 (to $1.08bn, compared to around $600-$850m in 2019-21).

More fundamentally, changes in PM’s volumes since 2018 should have raised its “real” earnings sharply.

Volume Transformation Since 2018

PM’s total cigarette and HTU volume declined with a CAGR of -2.3% in 2013-18, but the decline slowed to a CAGR of -1.7% in 2018-22 and just -0.9% if we compare Q1-3 2023 volume with Q1-3 2018 volume:

PM Cigarette & HTU Volumes (2013-22)

Source: PM company filings.

There has also been a mix shift to Heated Tobacco, whose volume has been growing, and away from cigarettes in Indonesia and the Philippines, whose volumes have been falling much faster than the group (including with a combined CAGR of -6.1% in 2018-23). These changes represent a significant improvement in PM’s earnings power, because Heated Tobacco carries about 50% better unit economics and likely higher customer retention, whereas cigarettes in Indonesia and the Philippines are lower-priced and will likely continue to experience higher churn.

Cigarette businesses have historically been able to deliver high-single-digit EPS growth from low-single-digit volume declines. PM’s total cigarette and HTU volume has fallen at an annual rate of just 1% since 2018 (as of 2023 YTD). Given the much better unit economics of HTUs, this implies that PM’s “real” EPS growth in the past few years is likely to be much better than high-single-digits, even if this is currently obscured by currency and IQOS expansion costs.

We have not included Swedish Match and ZYN nicotine pouches in the discussion above. However, U.S. ZYN has been described as having 500% better unit economics than non-U.S. cigarettes, and PM has expected the acquisition of Swedish Match to be EPS-accretive from year 1. Including Swedish Match and ZYN is likely to mean an even higher “real” EPS growth in the past few years.

Valuation: 16x P/E, 5.7% Dividend Yield

At $90.92, PM shares have a 16.1x P/E relative to its 2023 Adjusted EPS outlook, excluding Russia. (The mid-point of the 2023 Adjusted EPS outlook is $6.07, or $5.64 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 17.0x P/E, and the Free Cash Flow (“FCF”) Yield is 6.9%.

The Dividend Yield is 5.7%, with PM shares currently paying a dividend of $1.30 per quarter ($5.20 annualized), which was raised 2.4% in September.

Buybacks are suspended as PM continues to deleverage after the Swedish Match acquisition. Net Debt / EBITDA was 3.17x in September, down from 3.24x in June (despite a scheduled $1.7bn+ payment to Altria in July). Management expects to reach its target of “around 2x” by the end of 2026. We believe buybacks may resume in late 2025.

Philip Morris Stock Forecasts

We update our 2023 forecast to match the mid-point of the revised outlook, but leave other assumptions unchanged.

Our assumptions are:

• 2023 EPS to be $5.64 (was $5.58)

• 2023 dividend to be $5.20 (unchanged)

• Net Income to grow at 10% annually in 2024-26 (unchanged)

• Share count to be flat (unchanged)

• Dividends to grow at 2% annually (unchanged)

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

Our new 2026 EPS forecast is $7.51, 1% higher than before ($7.43):

Illustrative PM Return Forecasts

Source: Librarian Capital estimates.

With shares at $90.92, we expect an exit price of $165 and a total return of 102% (26.8% 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%↑. 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.