The tobacco industry has long been a source of exceptional shareholder returns. In some ways, this is not surprising. The economics of selling cigarettes and other tobacco products are highly attractive.

I’ll tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. It’s addictive. And there’s a fantastic brand loyalty.

– Warren Buffett

Philip Morris International (PM) – along with its sister company Altria (MO) – is considered one the ‘best of the best’ of the tobacco industry. The company has been operating in some shape since 1847 and currently has a dividend yield of 3.5%. These characteristics qualify Philip Morris to be a member of our Blue Chip Stocks List, a group of companies with 100+ year operating histories and 3%+ dividend yields. You can see the full list of blue chip stocks here.

Aside from its blue chip status, there are many reasons to appreciate this stock. Philip Morris’ entrenched leadership position in the international tobacco industry and its high dividend yield of 3.5% are two of them. This article will analyze the investment prospects of Philip Morris in detail.

Business Overview & Current Events

The first Philip Morris cigarettes were created in 1854. Since then, the Philip Morris family of companies has had a very convoluted corporate history, with a series of mergers, acquisitions, and spin-offs making it difficult to follow the company’s growth over time. The security discussed in this article – Philip Morris International common shares – have been publicly-traded since 2008, when they were spun-off from Altria. The purpose of this spin-off was to separate Altria’s domestic and international businesses.

Altria now handles the manufacturing and distribution of its cigarette products in the United States, while Philip Morris International performs the same tasks on an international basis. As a result, the two businesses are often called ‘sister companies’. Naturally, Philip Morris has a much higher level of geographic diversification than Altria. It also has a much higher exposure to fluctuations in commodity prices.

The impact of fluctuating exchange rates on Philip Morris’ financial performance is hard to overstate; in the most recent quarter, the company announced that currency effects alone should have a 14 cent per share impact on 2017 profits.

Source: Philip Morris International Second Quarter Earnings Presentation, slide 6

Currency continues to present a headwind for Philip Morris, but the company’s performance remains strong. On July 20, Philip Morris reported financial results for its fiscal 2017 second quarter. Adjusted diluted earnings-per-share increased 8.7% from 2016’s second quarter, driven by growing market share for its flagship Marlboro cigarette brand and continued growth from its smokeless IQOS products (notably in Japan). The company is expecting ~8% earnings growth in fiscal 2017, robust growth for a mature company that pays out ~90%+ of its earnings as dividend payments.

Growth Prospects

The widespread secular opinion on the future of the cigarette industry is quite pessimistic. As consumers become increasingly aware of the health consequences of smoking, cigarettes volumes will naturally decline. As the leader in international cigarette distribution, Philip Morris is certainly not immune to this trend. The company’s volumes decreased by 5% in the most recent quarter, primarily due to declines in Indonesia, Pakistan, the Philipines, Russia, and Turkey.

Source: Philip Morris International Second Quarter Earnings Presentation, slide 7

With that said, Philip Morris’ second quarter volume trends actually showed a sequential improvement over the volume numbers reported in 1Q2017. For the full-year of fiscal 2017, the company is expecting a total volume decline in the range of 3%-4%.

Source: Philip Morris International Second Quarter Earnings Presentation, slide 8

Fortunately, Philip Morris has a distinct strategy to counteract the negative growth in its legacy product categories. The decline in volume for traditional tobacco products should be more than offset by growth in the company’s ‘reduced risk products’ (RRPs) sales, which include heated tobacco products and other smokeless alternatives. The growth in this Philip Morris product category is simply amazing. In the second quarter of 2016, RRPs generated $615 million of net revenues. In the same period of the prior year, RRP net revenues were $123 million. This represents growth of 400% in a single year. In addition, the contribution of RRPs to Philip Morris’ aggregate net revenues grew from 0.9% to 8.9%.

Source: Philip Morris International Second Quarter Earnings Presentation, slide 10

If Philip Morris can continue growing its RRP sales at a rate even close to its rate over the past 5 quarters, then investors need not be concerned about the secular decline in traditional cigarette products. As RRPs grow to be a larger component of Philip Morris’ business, the company should return to a steady trend of earnings growth.

Competitive Advantage & Recession Performance

Philip Morris’ most compelling competitive advantage is its ownership of some of the most notable cigarette brands in the world. Most importantly, Philip Morris has international manufacturing and distribution rights for the Marlboro brand of cigarettes, one of the most popular cigarette brands in the world. Forbes estimates the Marlboro brand to be worth approximately $24 billion, making it the 25th most valuable brand in the world. Philip Morris’ strong brand recognition means its sales have decreased more slowly than its competitors in the age of tobacco decline. The company’s market share has grown as a result.

Source: Philip Morris International Second Quarter Earnings Presentation, slide 12

Philip Morris produces addictive consumer staples products, so the company enjoys a great deal of recession resiliency. The company barely noticed the Great Recession of 2007-2009:

• 2008 adjusted earnings-per-share: $3.32
• 2009 adjusted earnings-per-share: $3.24 (2.4% decrease)
• 2010 adjusted earnings-per-share: $3.92 (21.0% increase)
• 2011 adjusted earnings-per-share: $4.85 (23.7% increase)

Philip Morris’ earnings experienced a very minor ~2% drop in the last recession, before countering with two years of 20%+ growth. I would expect the company to enjoy a similar level of downside protection in future recessions.

Valuation & Expected Total Returns

Since its spin-off from Altria, Philip Morris International has done a subpar job of compounding its adjusted earnings-per-share. In 2008 – the year that Philip Morris was spun-off – the company reported adjusted earnings-per-share of $3.32. In 2016, this figure had grown to $4.48 at a CAGR of 3.8% per year. The company’s full earnings-per-share history since its spin-off can be seen below.

Source: Value Line

Looking ahead, it is possible that Philip Morris’ earnings-per-share growth is even lower than its historical ~4% per year rate for a period, at least until its RRPs become a much larger component of the overall Philip Morris business. This is partially because the company’s dividend has grown at a much faster rate than its earnings-per-share, resulting in a growing payout ratio. In 2016, Philip Morris reported a payout ratio of 92%, leaving little capital left over to fund growth projects.

Source: Value Line

In spite of the company’s mid-single-digit earnings-per-share growth, Philip Morris’ shareholder returns have been exceptional. Returns have been driven by a steady expansion in the company’s valuation multiple over time. Unfortunately, this means that the company’s valuation is highly elevated today. Since the company is more than halfway through its fiscal 2017, it is best to evaluate its current price using 2017’s expected earnings. Philip Morris’ second quarter earnings release saw the company revise its full-year 2017 adjusted earnings-per-share guidance upwards to $4.78-$4.93. Importantly, the midpoint of this guidance range ($4.89) represents healthy growth of 8.4% from 2016’s figure. The new $4.89 earnings expectation combined with the company’s current stock price of $117.82 gives a price-to-earnings ratio of 24.1. The following diagram compares Philip Morris’ current valuation to its long-term average.

Source: Value Line

Philip Morris International’s current price-to-earnings ratio of 24.1 is a ~48% premium to its average price-to-earnings ratio of 16.3 since the company was spun-off from Altria back in 2008. Regardless of underlying business growth prospects, now is not the time to buy Philip Morris. The company is quite overvalued, which will meaningfully reduce the long-term returns of today’s investors even if the underlying business grows at a satisfactory rate.

“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

– Warren Buffett

Final Thoughts

Philip Morris is a textbook example of a high-quality business trading at an exorbitant valuation. Although the company’s reduced risk products portfolio should propel its growth over the long run, its current valuation is simply not justified. Patient investors should wait for a better buying opportunity to add Philip Morris shares to their portfolio. Existing investors should continue to hold, adding on any significant dips and collecting the company’s juicy dividend yield in the meanwhile.