Philip Morris Stock: Smoking Is The Past, Nicotine Is The Future

With such a high and sustainable dividend, capital gain takes a back seat. In 1963 about 4,345 cigarettes were consumed per adult in America, marking an all-time high in cigarette consumption. At that time countless studies showed how harmful the smoking habit was, and since that 1963 an endless downward parabola has begun. Over time smoking has become socially unacceptable, and 60 years after that historic peak there is no shortage of new legislation against tobacco use. After all, this addiction still causes the deaths of 8 million people a year. To date, many smokers would like to quit but cannot. We all know how harmful smoking is, and even the companies that market it are inciting consumers not to buy their products. Philip Morris' slogan is now "Unsmoke Your Mind", yet 68% of its revenues come from the sale of combustible tobacco. At first glance this may seem incoherent and meaningless: what company would advise its customers not to buy its products? For decades, multinational tobacco companies have dominated the international scene without even having the opportunity to sponsor their products, but has their end really come now as many claim? How can these companies be a good investment if the main source of their revenues appears to be increasingly in trouble? In this article I will shed some light on these issues, focusing on what I believe to be the best company in this area: Philip Morris (NYSE:PM). As is often the case when analyzing this market, the first graph that is highlighted is the declining percentages of tobacco users. Clearly, there has been a major slump since 2000, and to date we are a long way from those numbers. At the same time, however, what goes by the wayside is that this statistic is rather misleading, as the world population is certainly not the same as it was 20 years ago. In percentage terms there has been a sharp decline, but the number of world tobacco users has remained almost unchanged. Globally, there were 1.39 billion smokers in 2000, while estimates for 2025 present only 98 million fewer smokers. This is not an insignificant reduction, but neither is it so relevant as to signal the end of this market as many believe. Tobacco use is still widely entrenched all over the world. Moreover, we can see that for the poorest regions, the number of smokers is even expected to increase by 2025. This is a crucial factor, as it manages to cover the sharply declining number of smokers in both the Americas and Europe. In any case, it is worth mentioning that Philip Morris is not exposed to the reduction in tobacco consumption in the United States unlike its rival Altria: the former licenses the Marlboro brand internationally, while the latter only presents the brand license in the United States. Focusing on Philip Morris' last three annual reports, indeed revenues are following the underlying trend just illustrated: Overall, the combustible tobacco segment generated net revenues of $21.57 billion in 2022, only $175 million less than 2020. In light of these results, in my view, the tobacco market is far from dead. Certainly the long-term trend is negative and we can notice this from the stalled/negative revenues, but it still remains a reliable business on which Philip Morris has a high international market share, 23.60% (excluding China and the United States). Profitability and resilience are two prominent aspects when it comes to the combustible tobacco market. Philip Morris is able to stably have a Free cash flow margin and a Return on Capital above 30%, which is something outstanding. The figures for the last few years cannot be attributed solely to the sale of combustible tobacco as they also include smokeless products, but in any case it gives an idea of how profitable this business is. Its resilience then, is unparalleled. Over the decades, every effort has been made to get more and more people to stop smoking, but this has not prevented Philip Morris' free cash flow from continuing to increase. This is a controversial result in my view, as it has been known for decades that tobacco is the single most preventable cause of disease and death in the world, yet this does not stop smokers. Negative anti-smoking advertisements, rising prices and permanent damage to health evidently are not a big enough incentive to stop this habit. I wonder then what might be. Once you become addicted to nicotine, it is extremely complex to get out of it, and this is the biggest problem for smokers and at the same time the biggest strength for Philip Morris shareholders. Eliminating advertising and limiting places to smoke have not eliminated a vice that humankind has had for millennia. Finally, it should be noted that Philip Morris can also act as a "buffer stock" in the event of any recession, another sign of resilience. Historically, demand for combustible tobacco has been constant and insensitive to price. No matter how much a pack of Marlboro will cost, and if the economy is in recession, a smoker will do anything to satisfy his addiction. Right or wrong to invest in so-called "sin stocks" there is no question that such a competitive advantage cannot go unnoticed in any way. High free cash flow margin, brand awareness, inelastic market demand and loyal customers are all the things a rational investor looks for in a company. Before 1990 it was possible to smoke even during a flight; today it is not even possible in some outdoor areas. Over the years, efforts have been made to restrict combustible tobacco use in enclosed and public areas as much as possible, partly because it was finally realized how harmful secondhand smoke was. In any case, to date the restrictions are certainly not over; on the contrary, they seem to be increasingly limiting. In 2023, there is no longer talk of not smoking in restaurants, but of banning smoking. The most striking recent case involves New Zealand, as people born after 2008 will not be able to buy cigarettes or tobacco products starting this year. In addition, tobacco retailers will drop to 600 (down from the current 6,000) and the amount of nicotine in products will be reduced to make consumers less addicted. But how relevant is all this really to the tobacco market? In my opinion, if we considered only the New Zealand ban, then there is no need to worry about tobacco companies, as we are talking about a country with just 4 million adults. However, if we consider the ripple effect that could result from this decision, it could be a problem. What if other countries, following New Zealand's model, decided to follow the same path? This could be a problem indeed, but I think there are at least 3 reasons why I do not think such a tightening of legislative restrictions is likely in countries with lots of smokers. At a time when a country has millions of smokers or even tens of millions of smokers, it is almost impossible to think of eradicating the smoking problem by withdrawing combustible tobacco from the market. Smokers have such an addiction that it can be compared to that of a drug addict; in fact, smoking cessation is accompanied by numerous withdrawal symptoms including insomnia, headaches, irritability, anxiety, nausea and weakness. Think of a country with millions of people experiencing these symptoms simultaneously, and you will understand that banning tobacco is not a bright idea. If even death is not a big enough incentive to quit smoking then try to think how little value there would be in introducing a new law banning smoking. In my opinion, this would only be a strong incentive to increase the black market and organized crime. Over the years, prohibition has often been ineffective, as those who are addicted will find ways to satisfy their addiction, legally or otherwise. Moreover, even today there are huge problems with hard drug consumption despite the fact that they are illegal, I don't see why banning cigarettes should not be the same. In short, I think it is superficial and naive to believe that banning combustible tobacco is the solution. According to Philip Morris, taxation of tobacco products generates over $399 billion in government revenue, of which $329 billion comes from excise taxes and $70 billion from value-added tax (VAT). Not bad, but certainly not enough to cover the costs that tobacco has on society. In fact, just think that cigarette smoking cost the United States alone more than $600 billion in 2018. These costs include health care spending and reduced production due to the negative effects of smoking. Looking at Europe, the primary region in which Philip Morris operates, the situation is much the same, with some states imposing higher taxation than others but not always able to cover the social costs of tobacco. So, it tends to be difficult to view combustible tobacco as "a profitable business" for the government. In any case, what would be the solution otherwise? Prohibiting its sale would only encourage the black market, which brings no revenue to the government but only the negative consequences of smoking. Taxation at least partially limits the economic and social harm of tobacco, so I don't see why states should deprive themselves of this revenue. At this point someone might argue that, just as New Zealand did, the solution is not to ban tobacco overnight but to ban it for future generations. Again, I continue to have my doubts about this. In my opinion, banning 2009s from buying a pack of cigarettes to prevent them from starting to smoke is on par with imposing on minors the inability to drink beer: there will always be someone older who will buy the cigarettes/beer for them (beyond buying on the black market). In 2050 the minimum smoking age will be 42 in New Zealand, to believe that everything will go as planned seems too optimistic. Over the years we have failed to combat hard drugs, do you really think that in 2050 no 41-year-old New Zealander will have an addiction to smoking? In any case, even assuming that everything would turn out for the best and smoking will no longer be a problem in New Zealand as well as in other developed countries, there is one detail that is not irrelevant: we are fighting the wrong enemy. Countries around the world are trying to limit the consumption of combustible tobacco as much as possible, but at the same time they allow the sale of alternative products with the same doses of nicotine without any problem. In fact, even in New Zealand next-generation products (NGPS) such as vaporizers, nicotine pouches, or tobacco heating products (THPs) are perfectly legal. This controversial aspect will be the subject of the next section. Over the past hundred years, tobacco companies have generated billions and billions of dollars by selling a product that is harmful, expensive, and smells bad. Now try to think how much money they could make if that same product did not have all these negative characteristics. Well, this is becoming a reality, and faster than expected. When I first noticed that Philip Morris' new slogan is "Unsmoke your mind" I was quite surprised. What company would invite its customers to stop buying its products? Actually, this makes perfect sense, and is the basis of my thesis of investing in this company. The more time passes, the more socially unacceptable combustible tobacco becomes, so this is not a market that will be exploitable in the very long run. I do not doubt that in 50 years there will still be people smoking cigarettes, but it is likely to be an obsolete market. Something new was needed, and Philip Morris was forward-looking enough to figure out what. When the products you make are the number one cause of preventable death in the world you probably have to change something, and that is what Philip Morris has done. With the introduction of IQOS the tables have turned completely, as this product solves much of the problems associated with smoking. People are becoming increasingly aware of all these benefits, which is why IQOS has already surpassed 20 million users and its growth does not seem to stop. After all, quitting smoking cigarettes and switching to IQOS is a benefit for both the person and the company: As we can see from this table, the amount of nicotine in HEETS is comparable to that in Marlboro Gold, so on paper the two products are equally addictive on consumers. However, this is not actually the case. Much of the nicotine in cigarettes is burned and only between 20-50% is absorbed by the body. In HEETS, on the other hand, the tobacco is heated, which is why the body is able to absorb significantly more nicotine. So, HEETS not only do much less harm but are more addictive. In light of this consideration, in my opinion those who switch from cigarettes to HEETS will have a much harder time quitting smoking completely. Psychologically, he or she will feel safer about his or her health, and the incentive to quit partially loses its importance. Furthermore, the body will be even more addicted to nicotine. In short, Philip Morris seems to know one thing more than the devil. From a profitability standpoint, the numbers are proving Philip Morris' plan right. Revenues from smoke-free products are increasing rapidly and are managing to cope with the decline in the combustible tobacco segment. Moreover, as their presence in total revenues has increased, the free cash flow margin has also improved. In 2018 the weight of smoke-free products on total revenues was 13.79%, in 2022, 32%. What is more, it is worth pointing out that in 2022 Philip Morris suffered a negative foreign exchange effect of $1.52 billion, otherwise free cash flow would have been $11.25 billion. In any case, beyond the euro-dollar exchange rate at historic lows, the income strength of this company is surprising. Revenues continue to grow over the long term without experiencing any particularly bad years, and to all this must be added an uncommon profitability. How many other consumer staples have growing revenues and a free cash flow margin stably above 30%? The reason I believe Philip Morris has a leg up on smoke-free products is mainly due to its ability to have made the IQOS brand as something sought after and unique. Owning an IQOS has become a real fashion trend, and it gives people who use it a certain sense of belonging to a certain social status. However, such success is not sudden, in fact from the very beginning Philip Morris has taken great care of the design, distinguishing it from the crowd. On the official website it is also possible to get an IQOS customized to your preferences. This is yet another factor that makes a consumer's IQOS potentially unique and distinct from the crowd, something that certainly makes a difference. Even if another company presented the same basic idea, it still would not be the same, as by now the perception of the IQOS brand is already ingrained in the minds of consumers. Moreover, having leveraged a large and active social media presence so that the brand could spread especially among young people has certainly contributed on what IQOS is today. In short, other companies, in terms of product differentiation have been short-sighted because they assumed that there was little to innovate for this market. In my view, the competitive advantage of IQOS is considerable and years of strong growth will follow, however, I do not feel I can rule out the possibility that things may change in 10 to 15 years. For that matter, I also do not find an optimistic scenario plausible to such an extent that Philip Morris has a large part of the market share of smoke-free products. In any case, the gap from companies like Altria (MO) and British American Tobacco (BTI) is quite wide today, especially in terms of the weight of revenues from smoke-less products on total revenues: for the former 10.28% while for the latter 17.81%. We are far from Philip Morris's 32% and after the acquisitions of IQOS U.S. and Swedish Match the gap may increase even more, but this may be the subject of a next article. According to TIKR Terminal analysts, the next five years of Philip Morris will be more exciting than the recent past in terms of growth. At first glance, these estimates may be unexciting, but it should be considered that Philip Morris has experienced far less growth in past years. Considering an equivalent time interval, from 2017 to 2022, revenues showed a CAGR of 2% and free cash flow a CAGR of 5.72%. Furthermore, it is important to put this in context, we are certainly not dealing with a tech company. We are still talking about a consumer staples, so a free cash flow CAGR of 7% is not bad at all, also because profitability will remain one of the company's strong points. Since the combustible tobacco market cannot be relied on too much in the future, it is evident that a large part of this growth will be driven by smoke-free products. In particular, in the case of Philip Morris I believe that it will be driven by the Heat-Not-Burn segment, obviously dragged by the growing popularity of IQOS. The potential of this market is enormous, in fact according to Technavio a CAGR of 27.05% is expected from 2022 to 2027. Like it or not, the tobacco market is still extremely profitable, and its inevitable exit from the scene in the future will be replaced by less harmful products that are similarly if not more addictive. Philip Morris with its IQOS is innovating a market that never felt the need, which is why I believe it is the company with the most promising smoke-less portfolio at the moment. After all, already 1/3 of its revenues no longer come from the sale of combustible tobacco. Its cash flows are stronger than ever and its profitability is improving, two good reasons to believe that it will continue to issue a huge and growing dividend. The current dividend yield is close to 5%, thus so high as to almost put any capital gain on the back burner. Moreover, with a macroeconomic scenario that does not bode well, Philip Morris with its dividend yield could, if only slightly, make the recession less bitter for our portfolio. After all, even in a recession, smokers will still line up to buy their pack of Marlboros/HEETS.