Big Tobacco has prospered against pretty much everything — higher taxes, dreary health warnings, advertising bans and of course a sharp decline in the number of smokers. Take British American Tobacco for instance, which annual revenue and free cash-flow have doubled over the last decade; if you back out its stake in ITC, the group sells at just x7 cash earnings and for an 8% dividend yield.
The catch with BAT is that half of operating profits come from the U.S., while the "new categories" business — vapor, oral and tobacco heating products — has yet to print black ink despite scaling up fast. For those who argue that you can't have your cake and eat it too, Philip Morris may offer a more compelling alternative.
Few large caps rank as good as Philip Morris by the price-to-free cash-flow yardstick in MarketScreener's quantitative ratings. Valuation is admittedly nowhere near as attractive as BAT's, with shares trading just south of x15 cash earnings, but it still remains much below market averages.
That is in spite of a business that consistently delivers phenomenal returns on invested capital, in addition of sporting a significant advance in new categories. In effect, the smoke-free electronic device iQOS already brings in a third of Philip Morris' revenue. Adoption is growing fast and the segment should represent 50% of top line by 2025.
Meanwhile, the company still controls the largest share — roughly 20% — of the traditional cigarettes business worldwide. The latter is seeing steady volume declines, but this course is offset by formidable pricing power and stable consumption rates in emerging markets. As a result, earnings have held up remarkably well.
Tobacco is one of the most consolidated sector, protected by unassailable regulations and barriers to entry. And Philip Morris owns Marlboro, by far the industry's most valuable brand. This does not temper the urgency to improve sales of alternatives to cigarettes, but it does provide resilience and solid foundations to invest in the future.
Philip Morris has been a forerunner in the global RRP ("Reduced-Risk Products") category. With iQOS, the company has a 80% market share in heat-not-burn products. In addition, while innovators are rarely rewarded by superior unit economics, iQOS has higher net revenue and margin per stick than combustibles.
The product is available in 70 markets, with plans to get to over 100 markets within the next three years. It is hard not to salivate at the prospect of converting endless cohorts of smokers to new RPP products, especially if that allows Philip Morris to improve their already breathtaking 45% EBITDA margins in combustibles.
British American Tobacco, for its part, has instead chosen to focus on vapor with its Vuse brand. Time will tell which product — vapor or heat-not-burn — will dominate, but profits-wise iQOS is still sprinting far ahead. A reasonable assumption is that there will be room for both. iQOS seems to have won customer preference so far, but there are other considerations at stake.
An example would be the steep regulatory setback that Philip Morris suffered in the U.S., where the International Trade Commission has banned iQOS following a patent dispute with British American Tobacco. Philip Morris, which has granted Altria — its former parent — a license to sell the device in the U.S., plans to appeal the trade agency’s decision**.**
Generally speaking, Philip Morris has been willing to distance itself from the U.S., which is perceived as too risky despite remaining the most lucrative tobacco market. In a move that signals maximum prudence and differentiates its strategy from BAT's, the company recently called off the long-entertained prospect or a merger with Altria.
In other places, notably Europe, regulators have welcomed iQOS and favored its roll-out by limiting excise taxes. The idea was to lower pricing and incentive consumers to switch to less harmful smoking alternatives. This has helped Philip Morris, the leader in combustibles and first-mover in RPP, to consolidate its position as the largest marketing and distribution force in the industry.
Cannabis is the other massive call option beyond tobacco. The raw material, supply chain, regulatory scrutiny and distribution challenges are similar. Philip Morris is in an enviable position to leverage its formidable infrastructure and take part in a rapidly growing industry that is expected to be worth over $30bn in Europe aline within five years.
The greatest risk, as usual with the industry, would be punitive regulatory crackdowns. Combustibles are still the big money spinner, in particular at BAT. RPP alternatives have been encouraged but are themselves not without concerns to health authorities. With that being said, there are only finite gains that stiffer regulatory pressure can achieve. At some point it does more harm than good, for instance when it entices illicit trade and dries up bountiful tax revenue sources.