Business model

Philip Morris CR is the Czech subsidiary of the well-known tobacco group Philip Morris, which holds a 77.6% stake in Philip Morris CR. The company is headquartered in Prague and operates in the Czech Republic and Slovakia.

The business model of tobacco companies is simple and understandable. Cigarettes, cigarette accessories and e-cigarettes of certain brands are sold to customers.

Well-known brands of Philip Morris CR are Marlboro, L & M, Red & White, Philip Morris and Chesterfield. In addition, brands specifically for the Eastern European region, such as Petra Klasik and Sparta, are also sold.

Market and Competition Analysis

The tobacco market is an oligopoly market; very few suppliers meet many demanders. There are only British American Tobacco and Imperial Brands as competitors. Altria is also a tobacco manufacturer, but Altria and Philip Morris have divided up the markets: Altria is only present in the USA and Philip Morris in the rest of the world.

New Competitors

The tobacco market is a very concentrated market where it is almost impossible for new suppliers to gain a foothold. Due to takeovers in the past, there are only three major suppliers left on the Czech market (or in the Western world in general). These therefore have enormous economies of scale in the production, marketing and distribution of their products, so that the capital requirements for a new company would be too high to compete with the established groups on a global level. In addition, cigarettes are branded products. This means that most smokers remain loyal to their respective brand and do not change it, as they associate certain personal experiences with the brand and they assign themselves to a social class through a brand.

86.6% of all smokers have a specific brand, which they do not change. *1
In addition to the brand continuity of customers, government regulations, such as the advertising ban, make it difficult for new competitors to compete for customers at all.
A look at the age of existing companies shows how securely they can stay in the market without fearing competition.

Bargaining power of suppliers

The supplier strength is very weak. Tobacco is mainly grown in China, India, Brazil, the USA and Indonesia. In addition, there are also many Latin American countries that grow and export raw tobacco. In all the countries mentioned, there is no association or lobby of tobacco farmers. Only in the USA have there been government guarantees for prices since the 1930s. However, this system expired in 2004, so that here, too, small farmers are unorganized and have no significant bargaining power vis-à-vis their buyers.

Bargaining power of customers

Buyer power is also non-existent in the tobacco industry, as no single buyer has a position of market influence. By selling to millions of different people, Philip Morris CR is not exposed to any risk here either.

Threat of substitutes

For some years now, there have been e-cigarettes that can be considered a substitute for conventional cigarettes. Although these are enjoying growing popularity, there are few new companies offering them here as well. Instead, once again only the three oligopolies are competing with each other to offer the best product. Since the winner in this competition has not yet been determined and it is still unknown to what extent there can be coexistence between the different products (analogous to cigarettes), the substitutes carry a certain risk. In view of the special market situation in the tobacco industry, however, the risk must be rated lower than in the case of a substitute in another industry (e.g. Netflix vs. DVD), since here it is very unlikely that the established companies will be disrupted, but at most the market shares among the groups could change.

Competitive rivalry

The tobacco industry is already very consolidated and there is little incentive for companies to try to weaken their competitors. Instead, companies rely on “peaceful coexistence.” One indicator of this is that there are no price wars; in fact, all companies raise prices evenly by an average of 5% each year. These price increases are supported by all companies without there being any evidence of price collusion. This suggests that it seems optimal for the oligopolies to align their strategy in such a way that there is no strong competition that would harm their business.

In summary, Philip Morris CR is in a market where the cards have been dealt among the few participants for many years and no one has an interest in reshuffling the cards or trying to take them away from others.
In addition, there are no threats outside the companies, such as from buyers or suppliers, as no one can match the size of the tobacco giant.

Market share for conventional cigarettes and e-cigarettes (HEETS)

Industry development

For several decades, the number of smokers worldwide has been falling continuously by about 2-3% per year. In the industrialized countries, the decline in smoking is somewhat more rapid; in the emerging countries, it is much lighter.

The following graph illustrates the decline in smoking in the U.S. since 1965. Although the U.S. is to some extent an extreme example, as smoking rates have not declined as much in most other parts of the world, many wonder why one should even look more closely at investing in tobacco, given that demand is declining and there is very unlikely to be a counter-trend.

Intuitively, one would like to assume that the share price has also fallen by an average of around 2-3% per year since the decline in smoking, since this is the figure by which the volume sold is ultimately reduced.

However, a look at the developments in the share prices of the four largest tobacco manufacturers not only shows that there has been no decline in the share price or that the share price has developed in line with the overall market, but there has been a steady outperformance compared to the S&P 500. How can this be?

There have been two reasons for this performance in the past and another two reasons are very likely to be added in the future:

Cost reduction: Production costs have fallen as a result of lower transport costs for tobacco and state-of-the-art machinery that makes tobacco processing more efficient. However, this point had only a minor impact on the increasing profits of the tobacco companies and is negligible.

Price increase: In fact, price increases have been much more important than cost reductions. Every year up to now, prices have been increased by an average of 5%. This price increase is implemented by all tobacco manufacturers. Since the price increase (5%) is greater than the decrease in the number of smokers (2-3%), the tobacco companies earn more money every year. Price increases have been the most important and effective tool to increase profits and probably will be in the future.

Sales volume increases: With new innovations in the e-cigarette marketplace, a smoker is likely to buy more of a company’s products overall and thus spend more money.

Decreased smoking rates: It would be a fallacy from the past to project the decrease in smoking into the future, as it is not a linear change. Even though people usually tend to see linear changes, in the vast majority of cases they do not occur. That a linear development is nonsensical can be seen if one continues the linear trend.

Thus, there should be no smokers left in the year 2045!

The function of the number of smokers is a reverse exponential function (exponential decrease), which will probably rather now flatten out and stagnate only slightly at a relatively constant level.

Special situation in the Czech Republic/Slovakia:
The above situation of smoking decline referred to the USA (the “worst case” within the Western world). In the market on which Philip Morris CR, on the other hand, operates, there was no comparable smoking decline.
On the left, the development of the smoking rate in the Czech Republic; on the right, the smoking rate in Slovakia:

Unlike in the USA, the average annual smoking loss in the Czech Republic was not 2.5% but only 0.35% (!).
In Slovakia – the other sales market of Philip Morris CR – the picture is completely different:
Here the smoking decline is not even present at all, but the share of smokers is even growing!

 

In summary, it can be said that a look at the tobacco industry is more than worthwhile, as it is (and probably will be in the future) able to continuously increase profits despite the currently still declining number of smokers, due to falling production costs, higher prices for the consumer, increased sales volume and a reversal of the previous trend. Philip Morris CR has a very special role to play here. Not only do they benefit from the four factors that make higher profits possible, but there is also no problem for them to compensate for.

Strong moat of the tobacco industry

After a closer look at its particular nature, it can be said that the tobacco industry has a strong “moat” and has historically proven itself to be one of the most secure and resistant industries. Here again is a brief overview of the pillars of the insurmountable protective wall that the tobacco industry has drawn around itself:

  • No new competitors due to government regulation and industry with declining smoking numbers (oligopoly market)
  • recurring customers (comparable to subscription model) (cigarettes have been smoked since 1586) → predictable, stable and anti-cyclical revenues
  • strong brands (especially Malboro)→ belonging to a social class, linking emotions and experiences with brand, “social proof” and higher willingness to pay
  • Not affected by disruptive technologies

Profitability

The EBIT margin and not the return on sales is considered, as the companies are located in different countries and the different interest and tax costs would distort the picture of the profitability of a company.

The first thing that stands out is the low EBIT margin at Imperial Brands. This is due to the fact that the tobacco giant generates 30% of its sales through its 70% stake in the Spanish logistics company “Logista”. This company specializes in the delivery of tobacco, convenience food, medicines and lottery products. As the logistics industry has a much higher cost of capital than the tobacco industry, the cost of sales accounts for a large proportion of sales, which is why the EBIT margin is so low.

In terms of return on equity, it is noticeable that both Altria and British American Tobacco (BAT) have a higher return on equity than Philip Morris CR. However, return on equity alone is not meaningful, since one can also, for example, achieve a high triple-digit return on equity simply by having very little equity and very much debt. Thus, the return on equity must be considered together with the return on assets, which also takes debt capital into account. Here it is noticeable that at Philip Morris CR the return on equity and return on total capital are the least far apart. This indicates a low level of debt, which will be analyzed later.

In the case of BAT and Altria, it should also be mentioned that there have been major deviations from their five-year average in recent years.

In 2017, for example, BAT took over the American tobacco supplier Reynolds American Inc. and borrowed a large sum of money to do so. As a result, the return on assets fell rapidly.

Auch Altria hat seine Verschuldung in jüngster Zeit deutlich erhöht und seine Profitabilität auf absehbare Zeit abgeschwächt. So nahm es in den Jahren 2018 und 2019 insgesamt rund 15 Mrd. Dollar an neuen Schulden auf, um für 2,4 Mrd. USD eine Beteiligung an dem kanadischen Cannabisunternehmen „Cronos“ zu erwerben und sich für 12,8 Mrd. USD an dem E-Zigarettenunternehmen „Juul“ zu beteiligen.

As both BAT and Altria will continue to be concerned with high debt levels in the future, Philip Morris CR’s outperformance in terms of return on assets compared to its peer group is expected to be even stronger in the future.

 

Philip Morris CR’s high investment ratio in recent years has come from high investment in modernization and new acquisition of plant equipment.

The degree of wear and tear can be used to measure the age of operating equipment and thus predict for the future the extent to which future investments will have to be made and to what extent. After calculating this ratio, it can be seen that property, plant and equipment has only been depreciated at an average rate of 5% and is therefore relatively new.

Indeed, Philip Morris had invested a lot of money in their fixed assets from 2015-2019 and they can now reduce the investments again.

 

The other competitors have already depreciated much more of their fixed assets, which indicates an older condition of the fixed equipment. Therefore, Philip Morris CR’s competitors will face high capital expenditures in the future, which will reduce free cash flow.

Overall, Philip Morris CR has been more profitable than its competitors in recent years. Due to the higher indebtedness of the competitors and the lower maintenance costs at Philip Morris CR, it can be assumed that Philip Morris CR will significantly outperform its competitors in terms of profitability in the future.

Financial strength

Philip Morris CR’s negative net debt is unique compared to its peer group. The company has a large liquidity cushion and rising interest rates would not have a significant impact on the Group’s credit rating.

The Czech tobacco company also stands out very positively in terms of the goodwill share of equity. As this share is 0%, since no companies have been acquired, the probability of unscheduled write-downs reducing the equity reported in the balance sheet is also 0%. In the case of competitors, on the other hand, the high proportion of goodwill poses a risk of write-downs. For example, Altria had to write down $4.5 billion on its e-cigarette company Juul at the end of last year, which weighed heavily on its bottom line. Due to the high goodwill share in the peer group, further write-downs are possible, which would significantly strengthen Philip Morris CR’s position in the tobacco market.

Volatility of the stock

Philip Morris CR stock has historically proven to be exceptionally consistent:

It is important to note in the chart that on the day of the dividend payment, the share price is corrected downward by the respective dividend amount (see figure). The actual performance is therefore much higher if the dividends received are taken into account.

This results in a beta of 0.45. Beta is an indicator that measures how strongly a stock fluctuates compared to the overall market. With a beta of 1, for example, the volatility of a stock is identical to that of the market as a whole. In this case, that means Philip Morris CR fluctuates less than half as much as the overall market.
If you factor out the share price setbacks on the day of the dividend (often about -10% in one day), the beta is even lower. Even for a defensive industry like tobacco, this beta is below its average of 0.63. There is a reason for this: the shareholder structure.

Shareholder structure

The vast majority of shares are not on the open market, but in the hands of strong institutional investors. Only 18.8% of shares are privately held. In general, the lower the proportion of private investors, the lower the volatility. One advantage of the parent company’s high shareholding is that the stock is less sensitive to market turbulence, as Philip Morris will not sell the subsidiary’s stake in the event of a stock market crash. This also makes the stock very resistant to general market volatility. The beta of the stock is approximately 0.5, which means that the stock fluctuates only half as much as the market.

Management

Philip Morris CR’s policy is quite simple and predictable: Generate free cash flow for the parent company. No acquisitions, no experiments.
Since Philip Morris International (PMI) holds about ¾ of the shares in Philip Morris CR, they also determine the management policy. This has been unchanged for decades. PMI wants Philip Morris CR to distribute its profits. Investments in research or the like are not necessary, as these are made by PMI. If there is a new product innovation, Philip Morris CR can implement it for free and they will receive the associated patent.
Thus, management focuses on increasing profits to be able to pay out a higher dividend.

Valuation

The discounted cash flow analysis is used to determine the intrinsic value of the share. A cost of capital of 6% is assumed for Philip Morris CR. *3

Over the last 10 years, Philip Morris CR has been able to increase its profits by an average of 5.2% annually – in the last five years even by 13.2% annually.
In my forecast, I calculate with a pessimistic scenario that the group can increase its free cash flow by an average of 2.5% over the next ten years. This figure is only just above inflation and would only occur in the event of a smoking decline, which would be very massive, as Philip Morris CR could normally overcompensate for such a decline by raising prices.
For comparison, I still assume a growth rate of 0% (negative growth after inflation) and 5%.
After 10 years, I set the “Terminal Growth Rate” to 2%, which corresponds to the long-term inflation rate.

The current price is currently 580€; however, this also has to be adjusted. First of all, for the dividend payout, which will soon be around 60€ per share. This happens because otherwise you would receive two distributions within 13 months, which are actually designed for 24 months. In addition, an amount of 84.82€ per share is deducted, as this amount represents the net cash balance per share. For this purpose, only cash balances were considered (inventories, receivables and other current assets explicitly not) and all financial liabilities were deducted from them. This cash balance must therefore be subtracted from the share price or added to the fair value. I decided to subtract it to better represent the value of future cash flows. Thus, the actual price per share is 435.18€.

The free cash flow per share in 2019 was 72.20€.
Consequently, the free cash flow yield for a shareholder is: 72.2€/435.18€= 16.59%.

This undervaluation now results in two excellent starting positions that make this purchase so attractive.
First, the share has a theoretical upside potential of 135.14% to its fair value (2% scenario assumed). At the same time, the downside potential is limited by the pessimistic valuation, as there can only be an upside surprise potential. A sudden drop in the share price is very unlikely due to the strong anchor shareholders.
Of course, the stability provided by the anchor shareholders also prevents such sudden upward price movements. Instead, a long-term convergence to fair value seems realistic to me.
However, I also think that the stock cannot reach its fair value in the foreseeable future, as it is too unknown that a sufficient number of market participants would become aware of the undervaluation. However, the annual cash flows alone make the investment very profitable.
Second, the huge free cash flow yield provides a unique margin of safety. With a free cash flow yield of 16.59%, profitability could theoretically halve overnight (0.5*16.59%= 8.3%) and the shares would still generate a higher yield than the market.

In summary, the valuation of the stock shows a huge margin of safety. Both in terms of price potential and future free cash flows, the risks are minimal and the opportunities are very high.

Potential risks

To conclude the analysis of Philip Morris CR, I would like to discuss general risks for the tobacco industry and explain how I evaluate them.

 

  • social acceptance decreases→ lower attractiveness of smoking
  • foreign currency risk
  • increasing legalization of cannabis
  • political risk of price increases due to higher taxes up to total prohibition.

Personally, I think the risks are low; especially compared to the opportunities. Social acceptance of smoking has been declining for decades. Whereas in the 1970s people still smoked in movies, during interviews or in the office, today there are countless restrictions that make this impossible. However, tobacco companies have nevertheless been able to increase their profits during this time and, moreover, this effect is already firmly priced into the share price. This pricing even creates an opportunity: If the low point of social acceptance is reached in the near future, a reversal effect is also possible. This would come about if certain social milieus wanted to distance themselves from others (e.g. their parents) by starting to reach for the cigarette. Even if this effect is rather unlikely, I think it is more probable than that all people stop smoking.

As the shares are denominated in Czech crowns, there is a foreign currency risk.
However, the Czech koruna is considered one of the safest currencies in Europe and is known for its stability. The Czech central bank acts less expansively than the ECB. In addition, there is robust economic growth in the Czech Republic and inflation is constant.
These factors make the Czech crown one of the most popular currencies in Europe. This is the reason why it is even continuously appreciating against the euro (see picture):

Whereas one euro cost 35 Czech korunas in 2000, the figure is now only 26, meaning that the euro has lost around 25% in value against the Czech koruna since its introduction.
Due to the ongoing central bank policy of the Czech Republic, all factors are given that the Czech crown continues to develop better than the euro, so that I consider the foreign currency in this case rather as an opportunity.

I also see the legalization of cannabis as a negligible risk. In countries or states that have legalized cannabis, there has been no negative correlation between the number of smokers and the number of cannabis users. However, due to the small number of countries that have legalized cannabis, it is not possible to derive representative results-especially since legalizations have occurred only in recent years.
In fact, cannabis is a substitute for tobacco in a way that no other drug is. However, the tobacco industry has been aware of this danger for a very long time. An internal Philip Morris document from 1960 shows the intensity with which the company has been pursuing cannabis legalization for over half a century. Documents published in the 2012 University of California academic book “Waiting for the Opportune Moment: The Tobacco Industry and Marijuana Legalization” show that tobacco companies have been preparing for cannabis legalization for a long time.*4 For example, if cannabis legalization were to occur, they would enter the market immediately and be able to mass produce certain products containing both cannabis and tobacco through patented production processes. Thus, they make it difficult for new suppliers to enter the market and try to maintain their oligopoly position in the new market as well.

 

However, Philip Morris CR is exposed to the political risk of tax increases quite significantly. In fact, taxes in the Czech Republic are among the lowest in Europe (€0.21 per pack). This means there is still plenty of room for improvement. The EU could also decide on a minimum taxation. However, Philip Morris CR has sufficient capacity to easily shoulder an increased burden. Basically, however, I think that the “coexistence” of state anti-smoking campaigns and the existence of the tobacco industry will continue, since the state also depends on tobacco taxes and thus has no interest in “slaughtering its goose.”
In addition, the state is aware that it must not set taxes on tobacco products exorbitantly high, as otherwise a black market for tobacco products would form, which the state would no longer be able to control and which would be accompanied by enormously high costs for the lost tobacco taxes and criminal prosecution.

Conclusion

The opportunities exceed the risks many times over and there is a large margin of safety. Particularly noteworthy here is the insurmountable moat created by regulation, the desire to smoke, strong brands and the lack of substitution opportunities for Philip Morris CR, which guarantees crisis-proof and long-term revenues. Pricing power results in high cash flow returns that are passed on to shareholders. Philip Morris CR’s balance sheet strength is an immense advantage in any scenario. In the event of higher tobacco industry costs, some competitors would face significant problems, while Philip Morris CR has a sufficient liquidity cushion and could potentially gain market power.